Introduction to Chapters 9 through 11

• Author: Deborah A. Geier
• Pages: 258-259

-258-

Unit IV:

Everything You Ever Wanted

To Know About Debt but Were Afraid To Ask

Introduction to Chapters 9 through 11

Debt, or leverage, is an extremely important (and growing) element of the economy, as many

business and financial investments are made with borrowed money, often not because of need but

because of an attempt to increase total returns, which also increases risk if the investment does not

perform as anticipated.

For example, assume a no-tax world in which Veronica and Victor each have $100,000 in cash

to invest. Veronica uses her funds to purchase one rental property (nondepreciable land rented to

tenant farmers, to keep the analysis simple) for $100,000 in cash, which she rents to a tenant at a

monthly rent of $1,000, or $12,000 per year. At the end of five years, the land has appreciated in

value to $130,000, and she sells the property.

Victor uses his funds to purchase five rental properties (nondepreciable land rented to tenant

farmers) for $100,000 each, making a $20,000 cash down payment and borrowing $80,000 at an

interest rate of 4% with respect to each property. Thus, Victor borrows $400,000 in the aggregate

and pays $16,000 in annual interest ($400,000 x .04). Like Veronica, he rents each property to a

tenant at a monthly rent of $1,000, or $12,000 per year. At the end of five years, each property has

appreciated in value to $130,000, and Victor sells them and repays the borrowed $400,000.

Putting tax consequences asi de, compare the aggregate pre-tax profit for each on these identical

$100,000 cash investments.

Veronica invests $100,000 Victor invests $100,000

buys 1 land tract for $100,000 cash buys 5 land tracts, paying $20,000 in cash and

borrowing $80,000 at 4% interest for each,

with $400,000 borrowed in the aggregate

annual rental income: $12,000 annual gross rental income: $60,000

less annual interest cost: 16,000

annual net rental income: $44,000

total rental income over 5 years: $60,000 total net rental income over 5 years: $220,000

sale: $130,000 less $100,000 cash sale: $650,000 less $100,000 cash investment

investment = $30,000 profit less $400,000 principal repayment = $150,000

profit

total profit: $90,000 ($60,000 plus total profit: $370,000 ($220,000 plus $150,000)

$30,000) = 90% ($90,000/$100,000) = 370% ($370,000/$100,000)

$190,000 cash in hand $470,000 cash in hand