How Much Debt?
The difficult questions facing the borrower is the optimal amount of debt to use in financing the investment. In our previous example, we saw that the use of debt increased the return on equity from 8.78 to 9.20 percent. And we noted that the equity position is also subject to more risk with the use of debt. Is there any “net” benefit to the use of debt?
Let us return to our example. If, with the use of debt, the borrower’s required rate of return increases from 8.78 to 9.20 percent, there is no benefit. At a required rate of return of 8.78 percent without debt, the net present value is zero. At a required rate of return of 9.20 percent with the use of debt, the net present value is still zero. Thus, there would be no “net” benefit.
Suppose, however, that with the use of debt the investor decides that the required rate of return with debt is 9 percent. In this case, there is a net benefit since at this rate the net present value will be positive. If all investors, however, used this required rate of return, they would bid up the value of the real estate, thus forcing the net present value back to zero.
The moral is that if you want the benefits, you have to pay the price. The increased equity return is possible only because of the greater risk to which the equity position is exposed.
