Corporate Finance: The Basics by Terence C.M. Tse

Author:Terence C.M. Tse [Tse, Terence C.M.]
Language: eng
Format: azw3
ISBN: 9781138695580
Publisher: Taylor and Francis
Published: 2017-08-31T04:00:00+00:00

In the “gain” outcome, Bob gets £150 at the end of the project. Unlike in scenario 1, more than one deduction needs to be made, including £16 of interest and the £80 repayment to Charlie, as well as Bob’s £20 outlay. This all leads to a final amount of £34. But here is the trickier part: what should this £34 of return be divided by? It is not £100. Why? Because, unlike in scenario 1 (where the £100 outlay is fully funded by Bob), the financing arrangement is made up of both Bob’s own money and Charlie’s loan. To answer the question, let’s ask who is entitled to the £34. Rightfully, it belongs to Bob only. This is because Charlie has already got her investment (the loan of £80) as well as her return (the £16 interest) when going through the deductions. So, to determine the rate of return, the £34 is divided by Bob’s contribution to the project outlay, which is £20. The rate of return is therefore 170 per cent! Running through the same logic, in the “loss” outcome, Bob’s rate of return would be a whopping negative 330 per cent!

How can the huge difference in the rates of return between the two scenarios, even though the project in both cases has exactly the same characteristics, be explained? A couple of observations can be made:

Debt amplifies both gains and losses. In comparison to Bob, Charlie makes a 20 per cent return in the second scenario from the interest, regardless of the eventual outcome that Bob faces. Figure 5.6 compares the returns that both Bob and Charlie can obtain. Figure 5.6 Returns to Bob and Charlie in both scenarios (not to scale)

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