Elena Martinez is thinking about investing in some residential income-producing

Question

Elena Martinez is thinking about investing in some residential income-producing property that she can purchase for $200,000. Elena 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 Elena 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 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.)

Explanation / Answer

Working for Elena Martinez Option 1 When she invests her own savings of $ 200,000 for purchasing the residential property $ Income from property per year 30000 Less : Income Tax per year @ 28% 8400 Annual Profit 21600 Return on Investment 10.8 % Option 2 When she borrows $ 150,000 at 8% interest $ Income from property per year 30000 Less : Interest on borrowings 12000 18000 Less : Income Tax per year @ 28% 5040 Annual Profit 12960 Return on Investment 6.48 % By investing 200,000 $ of her own funds, the leverage of the return on investment increases by 4.32%.

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