A broker wants to sell a customer an investment costing $100 with an expected pa
ID: 2678147 • Letter: A
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 percent 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 customers 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. Let customer’s expected return if she borrows the money =r 100 -90 = $106/(1+r) - 90*1.04/(1+r) 10= 12.4/(1+r) 1+r= 1.24 r=24% b. yes, borrowing makes investment more attractive. c. The debt has a fixed life and has a priority claim on cash flows in both operating periods and bankruptcy. This is because interest is paid before the claims to equity holders, and, if the company defaults on interest payments, it will be declared bankrupt, its assets will be sold, and the amount owed to debt holders will be paid before any payments are made to equity holders.
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