Question

28 warren is a business entrepreneur who runs his own online store, which he incorporated several years ago. he successfully borrowed money to start up the business, rather than using his own money and has since paid it back. once his business was stable, he borrowed again to buy a house.
he is now thinking of using leverage to invest in mutual funds. why is warrens decision to borrow money this time risky?
a. he wants to invest in mutual funds, which is a short - term investment not suitable for leveraging.
b. if the investment fails, he will lose both his home and business.
c. leveraging to invest fails result in longevity risk if he cannot pay back the loan in time.
d. he could lose his principal and interest, thus magnifying his loss:

Explanation:

To determine why Warren's decision to borrow money is risky, we analyze each option:

• Option a: Investing in mutual funds (a long - term investment) with leverage for a short - term business (online store) is not the main risk of leveraging here. Leverage risk is about debt repayment and loss magnification, not the mismatch of investment and business term.
• Option b: Leverage can be used for various investments, including mutual funds. The key risk of leverage is not about the suitability of the investment for leveraging in general, but about the consequences of not repaying the loan.
• Option c: Leverage involves borrowing money (principal) and paying interest. If the investment (in this case, maybe related to his business or other investments) fails, he still has to repay the principal and interest. This means that if things go wrong, his losses will be magnified because he has to cover the borrowed amount and the interest on it, in addition to the loss from the investment itself.
• Option d: The problem doesn't indicate that his business is not stable now or that he can't pay back the loan. The risk of leverage is inherent in the concept of borrowing to invest, regardless of his past repayment history.

Answer:

c. Leveraging to invest can result in longevity risk if he cannot pay back the loan in time. He could lose his principal and interest, thus magnifying his loss.