PFIN 2nd Edition by Lawrence Gitman ,Michael Joehnk,Randall Billingsley

Exercise 6

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.)