Question

A broker wants to sell a customer an investment costing $100 with an expected payoff in one year of $106. The customer indicates that a 6 percent return is not very attractive. The broker responds by suggesting the customer borrow $90 for one year at 4 percent interest to help pay for the investment.a. What is the customer's expected return if she borrows the money?b. Does borrowing the money make the investment more attractive?c. What does the Irrelevance Proposition say about whether borrowing the money makes the investment more attractive?

Answer 1

Answer:

a. return rate ,r =24%

b. Yes

c. see the explanation below

Explanation:

a. Let's represent customer’s expected return if she borrows the money with 'r'

100 -90 = $106/(1+r) - 90*1.04/(1+r)

10= 12.4/(1+r)

1+r= 1.24

r=24%

b. It is obviously true that borrowing makes investment more attractive .

c.  In both operating periods and bankruptcy, the debt has a fixed life and has a priority claim on cash flows. This is due to the fact that interest is paid before the claims to equity holders, and should in case the company fails on interest payments, it will be declared bankrupt, its assets will be sold, and  before any payments are made to equity holders, the amount owed to debt holders will be paid