Jamie 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 their own funds or (b) borrows $150,000 at 8%. Then discuss the effect, if any, of leverage on his rate of return. (hint: earnings before interest and taxes minus interest expenses equals earnings before taxes minus income taxes ( @28%) equals profit after taxes.
To calculate Jamie's annual profit and return on investment, we need to consider two scenarios:
Scenario (a): Paying the full $200,000 from her own funds
In this scenario, Jamie invests $200,000 of her own money. The property generates $30,000 per year in income before interest and taxes.
1. Annual profit before taxes:
Total Income - Expenses = $30,000
2. Annual profit after taxes:
Annual profit before taxes - (Annual profit before taxes * Tax rate) = $30,000 - ($30,000 * 0.28) = $21,600
3. Return on Investment (ROI):
(Annual profit after taxes / Investment) * 100 = ($21,600 / $200,000) * 100 = 10.8%
Scenario (b): Borrowing $150,000 at 8%
In this scenario, Jamie invests $50,000 of her own money and borrows $150,000 at 8% interest. The property still generates $30,000 per year in income before interest and taxes.
1. Annual profit before interest and taxes:
Total Income - Expenses = $30,000
2. Interest expense:
Loan Amount * Interest rate = $150,000 * 0.08 = $12,000
3. Annual profit before taxes:
Annual profit before interest and taxes - Interest expense = $30,000 - $12,000 = $18,000
4. Annual profit after taxes:
Annual profit before taxes - (Annual profit before taxes * Tax rate) = $18,000 - ($18,000 * 0.28) = $12,960
5. Return on Investment (ROI):
(Annual profit after taxes / Investment) * 100 = ($12,960 / $50,000) * 100 = 25.92%
Effect of leverage on ROI:
Comparing the two scenarios, we can see that using leverage to borrow $150,000 at 8% increases Jamie's ROI to 25.92%, compared to 10.8% if she paid the full $200,000 from her own funds. Leverage allows Jamie to amplify her return by using borrowed money, thus increasing her overall rate of return. However, it is important to note that leverage also increases the risk involved as it magnifies the impact of losses.
To calculate Jamie's annual profit and return on investment, we will consider two scenarios:
(a) Paying the full $200,000 from her own funds:
In this scenario, Jamie is not leveraging any borrowed funds. Therefore, her annual profit will be the income generated by the property minus any expenses:
Profit before taxes = $30,000 per year
Profit after taxes = Profit before taxes - (Profit before taxes * Tax rate)
= $30,000 - ($30,000 * 0.28)
= $21,600 per year
Her return on investment can be calculated by dividing the annual profit after taxes by the initial investment amount:
Return on investment = (Profit after taxes / Initial investment) * 100
= ($21,600 / $200,000) * 100
= 10.8%
(b) Borrowing $150,000 at 8% interest:
In this scenario, Jamie is leveraging borrowed funds. She invests only $50,000 of her own funds and borrows the remaining $150,000 at an 8% interest rate.
Interest expense = Initial borrowed amount * Interest rate
= $150,000 * 0.08
= $12,000 per year
Profit before taxes = $30,000 per year - Interest expense = $18,000 per year
Profit after taxes = Profit before taxes - (Profit before taxes * Tax rate)
= $18,000 - ($18,000 * 0.28)
= $12,960 per year
Her return on investment in this leveraged scenario can be calculated using the same formula:
Return on investment = (Profit after taxes / Initial investment) * 100
= ($12,960 / $50,000) * 100
= 25.92%
Effect of leverage on the rate of return:
In the second scenario where Jamie borrows $150,000 at 8% interest, her rate of return is higher compared to the first scenario where she pays the full $200,000 from her own funds. This is because the borrowed funds amplify her potential profit. However, it's worth noting that leveraging also increases risk, as any decreases in the property's income or value can also be magnified. Therefore, the effect of leverage on the rate of return depends on various factors, including the interest rate, property income, expenses, and market conditions.