Question

Q2: Investments with and without leverage                                                               (20 points)

[Note: Chapter 13 PPT slide 13-36 should be helpful]

You start a restaurant that requires $250,000 of capital. You decide not to borrow and invest all your money. If the restaurant makes $40,000 of earnings before interest and income taxes in the first year of business, find your return on investment. Assume tax rate is 20%.

If you decide to borrow 60% of the required capital at an interest rate of 7%, find out the return on investment.           

Show all your calculations.

Answer 1

To calculate the return on investment we will use the following formula-

ROI = net income/capital invested x 100

For no borrowing type of structure,

Net income = $40,000 x (1-0.20) = $32,000

ROI = $32,000/250,000 x 100

= 12.8%

For borrowing 60% of capital at 7%,

borrowed capital = $250,000 x 0.60 = $150,000

Own capital = $250,000 - $150,000 = $100,000

Net income = $40,000 - interest - tax

= $40,000 - $10,500 ($150,000 x 7%) - $5,900 [($40,000-$10,500) x 0.20]

= $23,600

ROI = $23,600/ $100,000 x 100

=23.6%

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