UCLA ECON 103 - Chap012 (2) (21 pages)

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Chap012 (2)



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Chap012 (2)

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Pages:
21
School:
University of California, Los Angeles
Course:
Econ 103 - Introduction to Econometrics

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Chapter 12 Financial Leverage and Financing Alternatives Solutions to Questions Chapter 12 Financial Leverage and Financing Alternatives Question 12 1 What is financial leverage Why is a one year measure of return on investment inadequate in determining whether positive or negative financial leverage exists Financial leverage is defined as benefits that may result to an investor by borrowing money at a rate of interest that is lower than the expected rate of return on total funds invested in a property To determine whether leverage is positive favorable or negative unfavorable the investor needs to determine whether the IRR calculated over the entire holding period is greater than the cost of borrowed funds A first year measure of return such as the overall capitalization rate can not be used because it does not explicitly consider the benefits that accrue to the investor over time from changes in income and value that do not affect the cost of debt Question 12 2 What is the break even mortgage interest rate BEIR in the context of financial leverage Would you ever expect an investor to pay a break even interest rate when financing a property Why or why not The BEIR is the maximum interest rate that could be paid on the debt before the leverage becomes unfavorable It represents the interest rate where the leverage is neutral neither favorable or unfavorable The BEIR remains constant regardless of the amount borrowed that is 60 70 or 80 percent of the property value An equity investor probably would not pay a break even interest rate when financing a property because the investor just earns the same after tax rate of return as a lender on the same project Borrowing at the BEIR provides no risk premium to the investor Normally a risk premium is required because the equity investor bears the risk of variations in the performance of the property Question 12 3 What is positive and negative financial leverage How are returns or losses magnified as the degree of leverage



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