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
In order to calculate the return on investment (ROI) in both scenarios, we need to consider the earnings from the investment and the cost associated with it. Let's calculate the ROI assuming (a) paying the full $200,000 from her own funds and (b) borrowing $150,000 at 8%.
(a) Paying the full $200,000 from her own funds:
To calculate ROI, we need to determine the profit after taxes and divide it by the initial investment. Let's break down the calculation step by step.
1. Earnings before interest & taxes (EBIT): This is the amount of profit before considering interest expenses or taxes.
2. Interest expenses: Since there is no borrowing in this scenario, there are no interest expenses.
3. Earnings before taxes (EBT): EBT is calculated by subtracting any interest expenses (which are absent in this case) from EBIT.
4. Income taxes: Multiply EBT by the tax rate of 28% to calculate the income tax amount.
5. Profit after taxes: Subtract the income taxes from EBT to get the profit after taxes.
6. ROI: Divide the profit after taxes by the initial investment ($200,000) and multiply by 100 to convert it to a percentage.
(b) Borrowing $150,000 at 8%:
In this scenario, we need to factor in the interest expense related to the loan. Let's calculate the ROI step by step.
1. Earnings before interest & taxes (EBIT): This is the same as in scenario (a).
2. Interest expenses: Multiply the borrowed amount ($150,000) by the interest rate (8%) to calculate the interest expense per year.
3. Earnings before taxes (EBT): Subtract the interest expense from EBIT.
4. Income taxes: Multiply EBT by the tax rate of 28% to calculate the income tax amount.
5. Profit after taxes: Subtract the income taxes from EBT to get the profit after taxes.
6. ROI: Divide the profit after taxes by the initial investment ($200,000) and multiply by 100 to convert it to a percentage.
Effect of leverage on the rate of return:
Leverage refers to using borrowed funds to finance an investment. In scenario (b), borrowing $150,000 amplifies the initial investment and potentially increases the rate of return. This is because the interest expense is deducted from the earnings before taxes, which reduces the taxable income and ultimately the income tax amount. As a result, the profit after taxes may be higher in scenario (b) compared to (a), leading to a potentially higher ROI due to the effect of leverage.