Bonus Business Question Help 4 Class?

Question

My cousin needs help with his hw and I have no idea what to do so I'm posting this question. No answers, just a start in the right direction...maybe someone could say what is the first and second step they would do to start this problem.

Joe can get a 20% Return on Equity without borrowing money from a bank. If Joe's initial equity is 10, 000 and he borrows 20, 000 at an interest rate of 18 % what Return on Equity can Joe expect from his investment. Should Joe borrow the 20, 000?

Thanks in advance : )

Answer 1

It's a trick question. From a math perspective, if (the big IF) Joe can get 20% return on his money and it costs him 18% to borrow the money, then it makes sense to borrow because he will get an extra 2% or the difference between 20% return and 18% cost.

So to answer the other question, Joe has $30,000 to invest and gets a $6,000 return (20% of $30,000) and Joe pays $3,600 in interest expense (18% of $20,000). That means Joe gets a net return of $2,400 ($6,000 less $3,600). Therefore Joe's return is 24% ($2,400 over $10,000) and that is why it's a trick question.

Think of it this way, if Joe never borrowed the money, he would have $10,000 to invest and could have made $2,000 based on his 20% return. However, Joe made more than 20% because he got an extra 2% (the difference between 20% and 18%) on the $20,000 loan and 2% of $20,000 is $400. That is how Joe ended up with $2,400 -- $2,000 from his own money and a net $400 from borrowing money from the bank.

Answer 2

I'll assume that you are talking about a one year period.

If Joe invests just 10,000, he expects to get a return of 2000 in the first year.

If he invests 30,000, he expects to get a return of 6000 in the first year, less interest expense of 3600.

His rate of return on the 30000 is the return divided by the investment.