Question

You are bullish on Apple Inc. shares which are currently trading at $100 per share. You have borrowed $50,000 to buy it on margin with an initial margin requirement of 50%. The maintenance margin is 30%. The interest rate on borrowed funds is 6% annually.

a. How much should you invest out of your own pocket to be able to buy it on margin? (6 pts)

b. How far can the stock price fall before you get a margin call? (8 pts)

c. If stock price increases by 15% during the next year, what is your rate of return? (6 pts)

Answer 1

a)

Since I have borrowed $50,000 to buy the stock and the initial margin requirement = 50%, I need to invest the 50% initial margin requirement = $50,000

Total Share proceeds = Borrowed Amount / Initial Margin

Total Share proceeds = $50,000 / 50%

Total Share proceeds = $100,000

Margin Investment Amount = Total Share proceeds - Borrowed Amount

Margin Investment Amount = $100,000 - $50,000

Margin Investment Amount = $50,000

b)

Margin call price = Current Share price * (1 - Initial Margin) / (1 - Maintenance margin)

Margin call price = $100 * (1 - 50%) / (1 - 30%)

Margin call price = $71.4286 or $71.43

c)

Share price next year = Current Share price * (1 + Expected return)

Share price next year = $100 * (1 + 15%)

Share price next year = $115

Interest Payment = Borrowed Amount * Interest rate

Interest Payment = $50,000 * 6%

Interest Payment = $3000

No of shares = Total Share proceeds / Current Share price

No of shares = $100,000 / $100

No of shares = 1000

Rate of Return = ((Share price next year - Current Share price) * No of shares - Interest Payment) / Margin Investment Amount

Rate of Return = (($115 - $100) * 1000 - $3000) / $50,000

Rate of Return = 24%