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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...
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…
References
Baye Michael, (2007), Managerial Economics and Business Strategy, McGraw-Hill/Irwin
Miller, M. H, (1991), Financial Innovations and Market Volatility, Cambridge, Massachusetts: Blackwell Publishers
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