Question 1

It is 2006 and you notice that there are a lot of television programs about people that flip houses. That is, programs in which people buy houses, remodel them, and hope to sell them at a profit. You think that this sounds intriguing and consider buying a house to sell one year later.

Assume that this house costs $250K today. The house, after you remodel it, will take on one of five market values next year: $150K, $200K, $250K, $300K, or $350K. Assume that remodeling the house is costless.

a) Suppose you have $250K in cash and decide to buy the house. What is your percentage return for each of the five possible house values next year? Graph your percentage return on the y-axis versus the percentage change in the value of the house on the x-axis. Draw a straight line through the five points. Hint: this is a trivial case where your percentage return exactly equals the percentage change in the value of the property.

b) Now suppose you only have $200K in cash. Your friend agrees to lend you the remaining $50K that you need, but only if you pay him back with 10 percent interest as soon as you sell the house one year later. You get the cash that is left over after selling the house and repaying your friend. Graph your percentage return on your personal $200K investment on the y-axis versus the percentage change in the value of the property on the x-axis. Draw a straight line through the five points.

c) Now suppose you only have $150K in cash. Your friend agrees to lend you the remaining $100K that you need, but only if you pay him back with 10 percent interest as soon as you sell the house one year later. You get the cash that is left over after selling the house and repaying your friend. Graph your percentage return on your personal $150K investment on the y-axis versus the percentage change in the value of the property on the x-axis. Draw a straight line through the five points.

d) Comment on the slopes of the lines from the previous three questions. Which scenario appears riskiest for your personal cash investment?

In this question, you can consider yourself the equity investor and your friend the debt investor. Notice what happens to the riskiness of the returns to the equity investor when there is a higher percentage of debt involved in the investment.