Explanation:
Joe and Mike both purchase identical houses which has a net worth of $200,000.
Down Payment made by Joe: $40,000
Down Payment made by Mike: $10,000
Down Payment is the total of his net worth for both individuals.
A) Who is more highly leveraged?
Mike borrowed $190,000 and Joe borrowed $160,000
Mike is more leveraged because he borrows much more to purchase a $200,000 house.
Mike's leverage ratio:
LR = $200,000/$10,000 = 20.
Joe's leverage ratio:
LR = $200,000/$40,000 = 5.
B) If housing prices in the neighborhood immediately fall by 10%, what would happen to Joe'sand Mike's net worth?
ROE = (ROA) (LR)
Mike:
ROE = (-10%) (20) = -200%
Mike will have a decrease of 200% in his net worth. He will surly go bankrupt as the value of his assets are less than the value of the liabilities on him.
Joe:
ROE = (-10%) (5) = -50%
Mike will have a decrease of 50% in his net worth. He still has the worth of his property because his assets are still greater than his liabilities.
