[question removed by moderator]
why are we comparing the interest rate to the discount rate since we are paying cash? and how the mortgage would increase the return?
Because the question asked you to compare the return when you’re paying cash to the return if you get a mortgage.
The difference between getting a mortgage and paying cash is that with the mortgage:
- Your equity is lower by the amount of the mortgage
- Your return is lower by the amount of the mortgage payments
We’re comparing the mortgage interest rate to the discount rate to determine whether the present value of the mortgage payments is greater than or less than the mortgage amount; it’s a short-cut way to determine whether the ROE will be higher or lower with the mortgage.
A larger percentage decrease in the initial investment than the percentage decrease in the profit.
Excuse me? Is this a joke? Why would equity be lower by the amount of the mortgage???
With cash payment your equity is lower and you don’t pay any interest so ROE is higher. The correct answer should be A in my opinion.
If you buy a house that is $1M and you pay cash, your equity is $1M.
If you buy a house that is $1M and you do 100% financing, your equity is zero.
If you buy a house that is $1M and you do 80% mortgage, your equity is $200K.
I dont see any jokes.
Incorrect. If you played with margin brokerage accounts, you would know that your leverage magnifies the return on equity. If the property grows you will have higher return over your invested amount assuming your mortgage interest is low.
OK.
It isn’t. And you’ve seen enough of my replies here to know that.
You’re familiar with balance sheets, no?
Suppose that you buy a $5,000,000 property.
No mortgage:
- Assets = $5,000,000
- Liabilities = $0
- Equity = $5,000,000
Eighty percent mortgage:
- Assets = $5,000,000
- Liabilities = $4,000,000 (= $5,000,000 × 80%)
- Equity = $1,000,000
And, of course, $1,000,000 < $5,000,000.
It isn’t. See above.
This is true.
Maybe. And maybe not. It depends on the interest rate on the mortgage.
An opinion I hope you’ve revised since you replied above.
If a company buys a property using cash, does its equity on balance sheet increase or decrease?
Neither.
Why do you ask?
Because in my opinion, if a company purchases a property using cash, it decreases its retained earnings, thus decreasing its equity. Seems like my existing understanding of equity concept so far is completely flawed
The question is asking about the ROE _ on this particular investment _, not the ROE for the company as a whole.
How was I supposed to now? ¯_(ツ)_/¯
I dont think this is the case whether the investment ROE or the company ROE.
If a company uses retained earnings to purchase an asset, the retained earnings decrease but doesn’t the asset grow the equity by the same amount? Then the company equity should be unchanged.
Well . . . now you do.
Did you really think that they were asking about the ROE for the entire investment company?
Yes, I really did. Thence my confusion. I’m sorry…
I guess that the easiest way to get it right is that in the topics on specific investments – equity, fixed income, derivatives, alternative investments – a question about ROE refers only to the specific investment being analyzed, whereas for FRA a question about ROE refers to the firm’s ROE as a whole.
That sounds sensible. Thank you much much
My pleasure.
No joke.