Jamie Thompson is thinking about investing in some residential income-producing property that she can purchase for $200,000. Jamie can either pay cash for the full amount of the property or put up $50,000 of her own money and borrow the remaining $150,000 at 8% interest. The property is expected to generate $30,000 per year after all expenses but before interest and income taxes. Assume that Jamie is in the 28% tax bracket. Calculate her annual profit and return on investment assuming that she (a) pays the full $200,000 from her own funds or (b) borrows $150,000 at 8%. Then discuss the effect, if any, of leverage on her rate of return. (Hint: Earnings before interest & taxes minus Interest expenses (if any) equals Earnings before taxes minus Income taxes (@28%) equals Profit after taxes.)
To calculate Jamie Thompson's annual profit and return on investment, we will consider two scenarios: one where she pays the full $200,000 from her own funds, and another where she borrows $150,000 at 8% interest.
Scenario (a): Paying the full $200,000 from her own funds
In this scenario, Jamie does not have any interest expenses to consider. Let's calculate her annual profit:
Annual Profit = Earnings before interest & taxes - Income taxes
Given that the property generates $30,000 per year after all expenses, we can calculate her annual profit:
Annual Profit = $30,000 - ($30,000 * 0.28)
= $30,000 - $8,400
= $21,600
To determine her return on investment, we need to calculate the percentage return on the initial investment:
Return on Investment = (Annual Profit / Initial Investment) * 100
Return on Investment = ($21,600 / $200,000) * 100
= 10.8%
Scenario (b): Borrowing $150,000 at 8% interest
In this scenario, Jamie has interest expenses to consider. Let's calculate her annual profit and return on investment:
First, calculate the interest expense:
Interest Expense = Loan Amount * Interest Rate
= $150,000 * 0.08
= $12,000
Now, calculate the earnings before interest & taxes (EBIT):
EBIT = Earnings before expenses (income) - Interest expenses
EBIT = $30,000 - $12,000
= $18,000
Next, calculate the earnings before taxes:
EBT = EBIT - EBT
= $18,000 - ($18,000 * 0.28)
= $18,000 - $5,040
= $12,960
Finally, calculate the profit after taxes:
Profit after taxes = EBT - Income taxes
= $12,960 - ($12,960 * 0.28)
= $12,960 - $3,628.80
= $9,331.20
Return on Investment = (Profit after taxes / Initial Investment) * 100
Return on Investment = ($9,331.20 / $50,000) * 100
= 18.66%
Effect of Leverage on Rate of Return:
Leverage refers to the use of borrowed funds to finance an investment. In the second scenario where Jamie borrows $150,000, her return on investment is 18.66%, compared to 10.8% when she pays the full amount from her own funds.
The effect of leverage is that it amplifies the return on investment. By using borrowed funds, Jamie is able to increase her potential return on the initial investment. However, leverage also increases the risk since Jamie has to pay interest on the loan. A higher return can result in higher profits, but it can also result in higher losses if the property's income decreases or the interest rates rise significantly.
It is important for investors to carefully consider the risks and rewards of leveraging their investments and assess their own risk tolerance before deciding to use borrowed funds.