Two friends each invested $20,000 of their own (equity) funds. Stan, being more conservative, pur­chased utility and manufacturing corporation stocks. Theresa, being a risk taker, leveraged the $20,000 and purchased a $100,000 condo for rental property. Considering no taxes, dividends, or rev­enues, analyze these two purchases by doing the following for 1 year after the funds were invested.

Question

(a) Determine the year-end values of their equity funds if there was a 10% increase in the value of the stocks and the condo.
(b) Determine the year-end values of their equity funds if there was a 10% decrease in the value of the stocks and the condo.
(c) Use your results to explain why leverage can be financially risky.

Answer 1

(a) Stan: Stock value increase: 0.10(20,000) = $2000
Equity value at year-end: $22,000 or a 10% increase

Theresa: Condo value increase: 0.10(100,000) = $10,000
Equity value at year-end: $30,000 or a 50% increase

(b) Stan: Stock value decrease: -0.10(20,000) = $-2000
Equity value at year-end: $18,000 or a 10% decrease

Theresa: Condo value decrease: -0.10(100,000) = $-10,000
Equity value at year-end: $10,000 or a 50% decrease

(c) Under high leverage situations, the gain or loss is multiplied by the leverage factor. If the investment goes down a small amount, the higher leverage loses much more than the unleveraged investment ($2000 loss for Stan vs. a $10,000 loss for Theresa). With gains, the return on equity capital is much larger for the higher-leveraged investment. This is why it is more risky.