(Unleveraged returns) You plan
(Unleveraged returns) You plan to invest $10,000 in a security,borrowing $6,000 of the cost from a friend, thus putting up $4,000of your own money. The cost of debt is 12%, and there are no taxes.With this arrangement, you expect a return of 20% on your equityinvestment. What would your return be without the leverage? Thatis, what would your return be if the entire $10,000 was your ownmoney?
Answer:
Given
Total investment = $10,000
Of total,
Debt = $6,000
Equity = $4,000
Cost of debt = 12%
Tax rate = 0%
Return on investment = 20%
As it is mentioned that the investment contains both debt andequity, the return on the investment can be considered as weightedaverage cost of capital (WACC)
Formula for WACC, given debt and equity investments is as shownbelow
Here
RE = cost of equity
RD = cost of debt
E = amount of equity
D = amount of debt
T = E + D
E/V = percentage of financing that isequity
D/V = percentage of financing that isdebt
t = tax rate
Substituting the values in the above equation, let us find theunknown, which is cost of equity RE
Given no taxes, hence t= 0%
0.2 = ($4,000/$10,000) * RE + ($6,000/$10,000) *0.12
0.2 * 10,000 = 4,000 RE + 6,000 * 0.12
2,000 = 4,000 RE + 720
1,280 = 4,000 RE
RE = 0.32
i.e, cost of equity = 32%
Now, if the person finances the total investment through his ownmoney, the equation will contain only the equity portion, debtportion will be zero
Hence WACC = E/ T * RE + 0
E= T = $10,000
Therefore, return will be RE = 32%
Hence, if the person is financing the total investment throughhis/her own money, the expected retuirn will be 32%.
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