CFA Level I · CFA Level I Exam · Types of Financial Returns
An investor buys a portfolio of 100,000 using 40,000 of her own equity and 60,000 borrowed at 5%. The portfolio earns 9% over the year. The return on the investor's equity is closest to:
The leveraged equity return is about 15.0%. The portfolio gain of 9,000 less borrowing interest of 3,000 leaves 6,000, which is 15% of the investor's 40,000 equity. Using 9% alone ignores leverage, while forgetting that the interest applies to the larger borrowed amount overstates the return.
- A9.0%
- B15.0%Correct
- C16.5%
Explanation
Portfolio gain = 9,000. Interest = 60,000 × 5% = 3,000. Net gain = 6,000 on equity of 40,000 = 15.0%. The 16.5% figure ignores the interest that must be paid on the loan relative to the borrowed amount incorrectly (using 9% × 100/40 less 5% × 60/40 would be correct, but 16.5% comes from adding 9% × 1.5 and subtracting only 5% × 0.5 ... ), and 9.0% ignores leverage.
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