1. What happens if the expected house value is much bigger? Rather than growing
ID: 2808280 • Letter: 1
Question
1. What happens if the expected house value is much bigger? Rather than growing to 140k, we know the house will increases in value to 160k. What is the ROE under different financing options? And how would you recommend the CFO finance this deal?
House Value – Year 1 (Purchase)
Money Put down by purchaser (Down Payment)
Bank Loan (Mortgage)
Interest Paid to Bank (10% loan – 50% tax bracket)
House Value at point of sale (after 3 years)
Net Return on house investment (increase in house value – payments to bank)
Return on Equity = Net Return / Money put down
$100,000
$100,000
0
0
$160,000
$100,000
$50,000
$50,000
$7,5000
$160,000
$100,000
$20,000
$80,000
$12,000
$160,000
House Value – Year 1 (Purchase)
Money Put down by purchaser (Down Payment)
Bank Loan (Mortgage)
Interest Paid to Bank (10% loan – 50% tax bracket)
House Value at point of sale (after 3 years)
Net Return on house investment (increase in house value – payments to bank)
Return on Equity = Net Return / Money put down
$100,000
$100,000
0
0
$160,000
$100,000
$50,000
$50,000
$7,5000
$160,000
$100,000
$20,000
$80,000
$12,000
$160,000
Explanation / Answer
Original Value = $100,000 , House Value at point of sale = $160,000, Increase in House Value = $160,000 -$100,000 = $ 60,000
Option 1:
Payments to Bank = $ 0 , Money Put down = $ 100,000
Net Return = $60,000 - 0 = $60,000
Return on Equity = $60,000/$100,000 = 0.6
Option 2:
Paymens to Bank = $50,000 + $7,500 = $57,500
Net Return = $60,000 - $57,000 = $3,000
Return on Equity = $3,000/$50,000 = 0.06
Option 3:
Payments in Bank = $80,000 + $12,000 = $92,000
Net Return = $60,000 - $ 92,000 = -$32,000
Negative return, Return on equity = -32,000/ 20,000= -1.6
Option 1 will be ideal.
Even if expected house will be bigger, the ROE will be higher for equity compared to debt because there will be no finance cost(interest).
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