2. 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 and taxes minus interest expenses (if any) equals earnings before taxes minus income taxes (at 28%) equals profit after taxes.)

Question

2. 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 and taxes minus interest expenses (if any) equals earnings before taxes minus income taxes (at 28%) equals profit after taxes.)

Answer 1

To calculate Jamie's annual profit and return on investment, let's consider both scenarios:

Scenario A: Paying the full $200,000 from her own funds
In this case, Jamie's investment is $200,000, and the property is expected to generate $30,000 per year after expenses. However, since Jamie is paying with her own funds, there are no interest expenses.

To calculate Jamie's annual profit, we need to deduct income taxes from the earnings before taxes. The earnings before taxes for this scenario would be $30,000. Given that Jamie is in the 28% tax bracket, her income tax would be 28% of the earnings before taxes, which is 0.28 * $30,000 = $8,400.

Now, let's calculate the profit after taxes: $30,000 - $8,400 = $21,600.

To calculate the return on investment, we divide the profit after taxes by the initial investment: $21,600 / $200,000 = 0.108, or 10.8%.

Scenario B: Borrowing $150,000 at 8%
In this case, Jamie is putting up $50,000 of her own money and borrowing $150,000 at 8% interest. The property is still expected to generate $30,000 per year after expenses.

To calculate Jamie's annual profit, we need to deduct both the interest expenses and the income taxes from the earnings before taxes. The interest expense for the loan would be 8% of $150,000, which is $12,000.

The earnings before taxes would still be $30,000. Calculating the income tax (28% of $30,000) gives us $8,400.

Now, let's calculate the profit after taxes: $30,000 - $12,000 - $8,400 = $9,600.

To calculate the return on investment, we divide the profit after taxes by the initial investment: $9,600 / $50,000 = 0.192, or 19.2%.

Effect of Leverage on Rate of Return:
Comparing the two scenarios, we can see that leveraging (borrowing money) has increased Jamie's overall rate of return. With her own funds (Scenario A), the return on investment was 10.8%, whereas with leverage (Scenario B), the return increased to 19.2%.

This effect occurs because Jamie is using borrowed money to finance a portion of the property's purchase. The rental income covers the interest expense, leaving her with more profit after taxes. As a result, her return on investment is higher in Scenario B than in Scenario A.

However, it's important to consider the risks associated with leverage, such as the potential for higher interest rates, fluctuations in rental income, and the need to repay the loan. These factors should be carefully evaluated before making a decision.