Question

Suppose a property can be bought for $2,500,000 and it will provide $200,000/year net cash flow forever, and you can borrow a perpetual interest-only mortgage secured by that property at a 7% interest rate, up to an amount of $950,000. (a) Does this present “positive” or “negative leverage,” and (b) why? (c) Do you think that the use of leverage, in this case, will increase the NPV of the investment for the equity investor in the property? (d) Why or why not?

Answer 1

Answer to Question (a) this will be a positive leverage

Answer to Question b), Rate of return from property = cash inflow / cost of property
Rate = $200,000 / 2,500,000		0.0800
Rate of return = 8%, interest rate is 7%, so this is positive leverage
The return from property is more than interest rate, so leverage will increase value
So this is positive leverage

Answer to Question (c),

The use of leverage, in this case, will increase the NPV of the investment for the equity investor in the property.

NPV = Present value of net cash inflow - equity investment
present value of perpetual cashflow = annual cash flow / interest rate or cost of capital
		perpetual cash inflowflow	200,000
		Interest on Olan of 950,000	66,500
		Net cash inflow	133,500
		Interest rate	7%
		present value of net cash flow	1,907,142.857
		Cost of property	2,500,000
		Loan	950,000
		Equity Investment	1,550,000
		NPV	357,142.8571

Answer to Question d),

The reason for increase NPV is the the interest is 7%, but return from the property is more than interest rate, so 1% after paying interest is constituting for increasing NPV.

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