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Hey everyone - brand new to the forums, but have used previous answers many times prepping for Level 1.
I have a question I can't find answered anywhere regarding Rate of Return on Leveraging. It's stumped me, my business partner and a couple colleagues.
This site does a great job explaining the main concept: https://analystprep.com/cfa-level-1-exam/equity/margin-transactions/
My example has to do with leveraging off a revolving credit facility like a Line of Credit. The issue is that you can invest with 0 equity (100% leverage).
A trader purchases $100,000 of a stock at 100% leverage (100% borrowed capital, no equity) with an 8% interest cost. The trader has no commissions and receives no income. A year later, the trader sells the stock for $125,000 (again, with no commission). The trader is charged 5% interest while the funds are borrowed.
Calculating the Profit:
i. This is where I can’t figure out how to calculate the rate of return, since you can’t divided $20,000 by 0. With 100% leverage, what is your equity?
ii. Logically to me, since my ‘equity’ exposure to this transaction was the cost of the interest, I would just divided $20,000 by $5,000, giving a return of 400%, but that doesn’t seem fully correct
Any insight would be appreciated!