Financial Management: Core Concepts, Third Edition

16.2 Benefits of Debt

Why would anyone ask to borrow money from Sherry at the whopping 900% rate or higher? Let’s see how it might play out. Say you have a project that has a 25% chance of paying off $5,000,000 and a 75% chance of paying off $0, but you need $100,000 for funding no matter what. On average, are you better off borrowing at 900% from Sherry or forgoing this project?

Let’s dissect this scenario. The expected payoff from the new project is

$$\text{expected payoff }\left(\text{project}\right)=0.25\times \text{\$}5,000,000+0.75\times \text{\$}0=\text{\$}1,250,000$$

and the expected profit, if you borrow from Sherry and repay $1,000,000 for the loan, is

$$\text{expected profit }\left(\text{project}\right)=\text{\$}1,250,000-\text{\$}1,000,000=\text{\$}250,000$$

So if you need $100,000 for the project and have no other source of capital ...