Expected return on leveraged investment with borrowed capital

Finance

Investments and the Irrelevance Proposition

The expected rate of return on an investment is calculated by taking the expected return and dividing it by the amount invested. If there is a return of $6 on an investment of $100 the rate of return is 6%.

When a customer states they are unhappy with this return, and it is suggested that they borrow $90 to help pay for the investment, which has an interest rate of 4%, the broker is suggesting that the investor goes from an unleveraged position where there is no borrowing, to a highly leveraged position, where there is a high level of borrowing.

Looking at the effect this will have on the investment the first consideration is to look at the investment itself; if the investor borrows $90 and invests $10 of their own, there is still a total investment of $100, and the return for the investor is still $6, so the rate of return on the investment remains the same. However, borrowing the money makes a difference to the net revenue that the investor will receive, as they are only using $10 of their own money, and borrowing the rest, then have to pay interest before receiving the net income. This calculation is shown in table 1

Table 1 Investment return calculation

Investment income (a)

$6.00

Interest to be paid on borrowed money (b)

$3.60

Net revenue (a - b) (c)

$2.40

As a percentage of $10 (c/10 * 100)

24%

The benefit has been the ability of the investor to move from the unleveraged to the leveraged position, increasing the amount that is available for investment, which increases the marginal rate of return.

Question 2

At first glance it may appear that this increases the attractiveness of the investment; borrowing the money results in an increased rate of return when calculated only on the investors won money. However, the reality is that the investment itself is still performing in the same way; giving a 6% return, the broker is showing an investor how to maximize their position by increasing the amount that is available for investment. There is no different return based on the source of the money, the margin rate of return for the investor changes as a result of a different investment strategy. The investment strategy may be more attractive to the investor.

Question 3

The irrelevance proposition refers to the way firms are valued by the market, considering whether the level of debt will impact on that valuation (Miller, 1991). The theory was developed by Modigliani and Miller, states that were there are efficient markets, the market value of a firm should be reliant only on its ability to generate future income streams created by its and not on its capital structure (Miller, 1991). In other words, when the value of the firm is assessed the debt-equity ratio is theoretically irreverent. This can be illustrated very simply with the case above, where the $100 generates an income stream of $6, regardless of whether the money is equity (owned by the investor) or debt (borrowed). The theory also states that the dividend policy which is adopted should also be seen as irrelevant, as the investment will still perform in the same way regardless of whether the dividends are distributed or reinvested.

It theory also states that the level of borrowing is not expected to impact on the firms weighted average cost of capital, and that the equity holders will be indifferent to the financial policy of the firm and their decision whether or not to increase or decrease debt (Miller, 1991).