Question

The use of financial leverage in purchasing an income-producing property can affect the amount of cash required at acquisition, the net cash flows from rental operations, the net cash flows from the eventual sale of the property, and the ultimate return on invested equity. Assuming the going-in IRR is greater than the effective borrowing cost, if an investor increases his leverage rate, say from 75% to 80%, we would expect which of the following to occur?A. Both NPV and going-in IRR to increaseB. NPV to decrease, while going-in IRR increasesC. NPV to increase, while going-in IRR decreasesD. Both NPV and going-in IRR to decrease

Answer 1

Answer:

A) Both NPV and going-in IRR to increase

Explanation:

The company's weighted average cost of capital (WACC) includes both equity and debt, and if the cost of equity is higher than the cost of debt, an increase in the percentage of debt will lower the company's WACC. The WACC is used as the discount rate to calculate the net present value (NPV) of the project.

If the discount rate is lower, then the present value of the cash flows will be higher, increasing the NPV. The internal rate of return (IRR) is the interest rate required for the NPV to be equal to $0, so if the NPV increases, then you need a higher interest rate to make it equal $0 (therefore the IRR is higher).