Edmonds Community College
Chapter 5 Cost of Capital and Capital Structure
Leverage (work with at least one other)
Leverage is an important concept for making money. Using leverage in banking allows you to make money on borrowed money.
I want to see how well you can use leverage on your own and as a group. I recommend you try this on your own first; then get a group together to compare notes and see what your best option is.
Imagine I give you $100,000.
You can borrow money from the ABC Bank at an annual interest rate of 6%. (We’ll assume simple interest throughout this project.)
You can put money in the bank and collect interest of 7%.
If you borrow money to buy one or multiple of the following investments you have to put down (down payment/collateral) of at least 10%. For example: If you buy a $200,000 house, you need to put down at least $20,000 (10% of the house value) and you can borrow $180,000. That would leave you with $80,000 to do something else with.
At the end of one year I want my $100,000 back. You can invest it for the next year buy doing any of the following, but after one year you have to sell whatever you bought. Collect the profits and give me the money back. You keep the rest. There is no cost to any of the transactions.
You can do the following (any combination):
Small houses cost $100,000 and gain in value by 9% per year.
Medium houses cost $150,000 and gain in value by 10% per year.
Big houses cost $350,000 and gain in value by 11% per year.
Putting money in the bank gains 7% per year.
You can also do nothing; put it under your mattress if you want. (Inflation will definitely get you this way.
Explain how you will work with your money, why and how much you made. Again, I advise you to do it on your own, ask questions amongst yourselves, and then come up with the best answer.
What is your debt to equity ratio?
One more option:
You can also buy a warehouse for 1,000,000 and rent it out for $100,000 per year. In this case I want my $100,000 back in three years. You do not have to pay me any interest. The building value goes up by 4% per year.
All interest rates are the same as above.
What is your debt to equity ratio?