Problem 2-14 Margin and Leverage (LO3, CFA4) Suppose you purchase 1150 shares of
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Problem 2-14 Margin and Leverage (LO3, CFA4) Suppose you purchase 1150 shares of stock at $82 per share with an initial cash investment of $47150. The call money rate is 5 percent and you are charged a 1.5 percent premium over this rate. Ignore dividends a. Calculate your return on investment one year later if the share price is $90. Suppose instead you had simply purchased $47150 of stock with no margin. What would your rate of return have been now? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places) 0 Answer is not complete. Rate of Return With margin Wthoul margin 97601% b. Calculate your return on investment one year later if the share price is $82 Suppose instead you had simply purchased $47150 of stock with no margm. What would your rate of return have been now? (A negative value should be indicated by a minus sign. Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)Explanation / Answer
(a) Current Stock Price = $ 82, Number of Shares Bought = 1150
Total Value of Shares Purchased = $ 94300
Investor's Own Equity = $ 47150
Amount Borrowed = 94300 - 47150 = $ 47150
Call Money Rate = 5 % and Broker Premium = 1.5 %
Total Margin Premium = 5 + 1.5 = 6.5 %
Margin Interest on Borrowing one year later = 47150 x 0.065 = $ 3064.75
Share Price one year later = $ 90
Share Value After One year = 90 x 1150 = $ 103500
Net Profit = 103500 - 94300 - 3064.75 (margin interest) = $ 6135.25
Return on Investment = Net Profit / Own Equity = 6135.25 / 47150 = 0.1301 or 13.01 % approximately.
Without Margin:
Initial Investment = $ 47150 (only)
Number of Shares Bought = 47150 / 82 = 575
Share Price After 1 Year = $ 90
Value of Investment After 1 Year = 90 x 575 = $ 51750
Return on Investment = (51750 - 47150) / 47150 = 0.0976 or 9.76 % approximately.
(b) Share Price after 1 year = $ 82
Share Value after 1 year = 82 x 1150 = $ 94300
Net Profit = 94300 - 94300 - 3064.75 (margin interest) = - $ 3064.75
Return on Investment = (-3064.75) / 47150 = -.0.065 or - 6,5 % approximately.
Without Margin:
As the share price remains unchanged a year later, the net profit is zero and so is the return on investment.
(c)
Share Price after 1 year = $ 66
Share Value after 1 year = 66 x 1150 = $ 75900
Net Profit = 75900 - 94300 - 3064.75 (margin interest) = - $ 21464.75
Return on Investment = (-21464.75) / 47150 = -0.4552 or - 45.52 % approximately.
Without Margin:
Share Price after 1 year = $ 66
Share Value after 1 year = 66 x 575 = $ 37950
Net Profit = (37950 - 47150) = - $ 9200
Return on Investment = (-9200 / 47150) = 0.1951 or -19.51 % approximately.
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