PFIN 3rd Edition by Lawrence Gitman,Michael Joehnk,Randall Billingsley

Exercise 7

Lilia Castillo is thinking about investing in some residential income-producing property that she can purchase for $200,000. Lilia 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 percent interest. The property is expected to generate $30,000 per year after all expenses but before interest and income taxes. Assume that Lilia is in the 28 percent 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 percent. 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 percent) equals Profit After Taxes.)