PFIN 5th Edition by Randall Billingsley,Lawrence Gitman,Michael Joehnk

Exercise 9

Investing in residential income-producing property. Wendy Irving is thinking about investing in residential income-producing property that she can purchase for $200,000. Wendy 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 wendy 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.)