Problem 3 asks you to consider borrowing to make an investment, which is what ma

Question

Problem 3 asks you to consider borrowing to make an investment, which is what many investors actually do to leverage their cash flow into wealth accumulation. So you need to compare an APR to an investment return (don’t forget that you have to pay the $1000 as well as the APR to buy the investment). Definition of rate of return is percent gained divided by percent invested. Or you can compare the dollar gain directly to the dollar cost of the investment to answer. Problem 3: Rudy and Karyn come across an investment opportunity that offers them a guaranteed return. The terms of the investment are as follows: Holding Period: 1 year Initial cost: $1,000 Guaranteed Sales amount: $1,800 The couple is excited by the opportunity but they don’t have enough liquidity to put the cash forward the investment. You propose a solution: borrow the $1,000 under their Credit Line 1 (credit terms for this line of credit are listed in Question 1) and put it towards the purchase of the investment. In one year, sell the investment for the guaranteed amount, collect the cash, and pay off the balance of the debt. Assume at this time that the investment amount is the only debt that the couple has taken on. How can you justify your proposal? What would be the net return of your proposal? Ignore the effect of taxes. (Hint: consider how the rate of return on the investment compares to the cost of borrowing money under this specific credit line)

Explanation / Answer

Cost of investment                    = $1,000

Guaranteed sales amount          =$1,800

Gain on sale                               = $1,800 - 1,000 = $800

Gain %                                       = $800/$1,000 x 100 = 72.73%

Borrowing Amount                     = $1,000

Note: To find cost of borrowing, interest rate is not given in the problem, but it is qiven in Q.no. 1, that information is not produced here.

Suppose, it is 10%; Borrowing cost will be = $1,000 x 10% =$100; if any other cost of debt is there, that also to be included in the cost of debt.

With this borrowing, gain is $800 and the cost of loan is $100; so the net return is $700 (i.e $800 -100)

Since, return on investment i.e 72.73% is greater than cost of debt i.e 10% or borrowing, it is worthful to borrow and invest. This type of investments are beneficial as long as the rate of return is greater than cost of debt.

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