week 8 2. In late 2007 you purchased the common stock of a company that has repo
ID: 2665904 • Letter: W
Question
week 82. In late 2007 you purchased the common stock of a company that
has reported significant earnings increases in nearly every quarter
since your purchase. The price of the stock increased from $12 a
share at the time of the purchase to a current level of $45.
Notwithstanding the success of the company, competitors are
gaining much strength. Further, your analysis indicates that the
stock maybe overpriced based on your projection of future earnings
growth. Your analysis, however, was the same one year ago, and the
earnings have continued to increase. Actions that you might take
range from an outright sale of the stock (and the payment of capital
gains tax) to doing nothing and continuing to hold the shares. You
reflect on these choices as well as other actions that could be taken.
Describe the various actions that you might take and their
implications.
Explanation / Answer
1) Sell the stock outright This incurs possible payment of capital gains tax, but allows allocation of funds to other potential under-priced stocks that could yield greater return for less risk 2) Continuing holding the shares No capital gains tax will be incurred, and with earnings increasing in strength, could see further profits. The risk is that the analysis has shown the stock is overpriced and could go down in value, causing unrealized losses - i.e. could have liquidated at a higher price 3) Liquidate a portion of the portfolio This combines both options above. Less capital gains are incurred, and can still benefit partially from any further stock gains. An example could be to liquidate enough of the stock to cover you cost base ($12) and leave the rest participate in capital gains This disadvantage is opportunity costs, the money could be allocated to other under-priced stocks 4) Sell short calls near the current level (covered calls) If stock drops, then the premium received for the calls is taken in full and partially hedges the potential profit lost. If the stock rises beyond the strike price sold, then the shares are liquidated at a high price + the premium received from the short calls. However this triggers CG Tax, and also extra slippage and brokerage costs surrounding the option transactions 5) Hedge with long put This essentially locks in a profit at the desired level, at the expense of a premium paid for the long put. It reduces the risk, and allows the holder to more comfortably hold the stock in case further gains in stock are experienced. Disadvantages: slippage and brokerage costs, including too high a premium paid. As before there is the opportunity cost of simply liquidating this stock and moving on to other targets.
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