Question

The current market price of a stock is $40 per share, and you have $8,000 of your own to invest. You borrow an additional $8,000 from your broker at an interest rate of 4.0% per year and invest $16,000 in the stock.

a.) What will be your rate of return if the price of the stock goes up by 6.0% during the next year?

b.) How far does the price of the stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately.

Answer 1

a. 8% b. $28.57 a. Calculate the rate of return: Increment in share investment - Interest expense Rate of return= Total borrowings $960 - $320 $8,000 8% Thus, the rate of return is 8%. Working notes: Change in share investment: Increase in share investment = Total investment * Increment rate = $16,000 x 6% = $960 Calculate the interest expense: Interest expense - Total borrowing Interest rate = $8,000 x 4% = $320

b. Calculate the stock price fall line in case of margin call of 30%: The value of 400 shares will be 400P. Required margin Equity Value of the shares Value of shares - Total borrowings Value of the shares 0.30 400P - $8.000 400P P= $28.57 Thus, the stock price fall line is $28.57. Working note: Calculate the number of shares: Number of shares Total investment Cost per share $16,000 $40 = 400 shares Please take your valuable time and rate the solution as per your convenience.