5. Suppose that you believe the fundamental value of Wal-Grey stock is about to

Question

5. Suppose that you believe the fundamental value of Wal-Grey stock is about to rise from $50 to $100 because of its new management team. You have $20,000 that you can risk in the market, where the market interest rate is 6%. You can think of four possible ways to profit:
a. use your $20,000 to buy shares of Wal-Grey;
b. borrow (a a 6% interest rate) an additional $20,000 on margin to buy a total of $40,000 worth of Wal-Grey stock;
c. enter into a futures contract to buy 400 shares of Wal-Grey in one year for $21,200 (you can invest safely for a year at a 6% interest rate).
Calculate how much you earn or lose buy each method if
(i) Wal-Grey stock rises to $100 per share in one year.
(ii) Wal-Grey stock stays at $50.

Explanation / Answer

<p>Method A) : if stock rises to 100, you would make $20000. If you have invested the money at interest rate, you would've earned 1200. So comparing to risk free investment, you are better off by 20000 - 1200 = 18800</p>
<p>if stock stays, you earn nothing, and the opportunity cost is 1200 (what you would've made if you have invested in risk free).<br /><br />Method B) : if rises, you make 40000 - 1200 = 38800. if stays you lose 1200. In addition, the opportunity cost is 1200.</p>
<p>Method C) : same as method A. (assuming the contract has to be fulfilled, meaning you HAVE to buy the shares even if stock price doesn't rise).</p>

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