A broker wants to sell a customer an investment costing $100 with an expected pa

Question

A broker wants to sell a customer an investment costing $100 with an expected payoff in one year of $106. the customer indicates that a 6 perent return is not very attractive. The broker responds by suggesting the customer borrow $90 for one year at 4 percent interest to help pay for the investment.

a. What is the cusotmers expected return if she borrows the money?

b. Does borrowing the money make the investment more attractive?

c. what does the irrelevance proposition say about whether borrowing the money makes the investment more attractive?

Explanation / Answer

a). expected return = return on invested fund + leverage ratio (return on invested fund- interest rate on borrow fund)

= 0.06 + 0.9( 0.06 - 0.04)

= 0.06 + 0.018

= 7.8%

Note:- investing by using borrowing fund with own fund

leverage ratio = debt / equity

=$90 / $100

=0.9

b). yes, Borrowing made the investment return increase by 30% (increased to 7.8%)

  note: increase in investment return = 7.8% - 6% / 6%

= 30%   

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