Question

Ivanka Clinton is a recent IUN graduate living in Gary Indiana and working in Chicago as a financial analyst. She maintains an aggressive investment posture including margin trading. She currently holds a $100,000 diversified stock portfolio in her margin account. The account has a debit balance of $40,000. She believes Trump Enterprises, which is selling at $20 per share, is about to soar to at least $50 per share in the next year. The company pays no dividends. The initial margin requirement is 50% and margin loans charge 10%. 1. Suppose Ivanka decides to buy 1000 shares of Trump Enterprises. Bear in mind this is a $20,000 transaction. . Assume Ivanka buys the shares with a $5,000 investment ($5000 of her own money) and a margin loan of $15,000. In a year Trump Enterprises rises to $60 per share. a. What is Ivanka’s return on the purchase of the Trump Enterprise stock? b. What is her return on the purchase of the Trump Enterprise stock if she uses her own money instead of the margin? 3. Suppose at the year-end Trump Enterprise sells for $21 per share. Rework 2a and 2b. 4. Suppose at the year-end Trump Enterprise sells for $15 per share. Rework 2a and 2b. 5. Evaluate Ivanka’s plan to pyramid. Discuss the risk and return.

Answer 1

1. Trump Enterprises rises to $60 per share by end of year

Net transaction value for buying Trump Enterprises = $20000 (20 x 1000)

Debt Capital = $ 15000 (margin requirement = $7500 interest = $1500 pa)

Investment = $ 5000

Trump Enterprises rises to $60 per share by end of year

Net value = $60 x 1000 = $ 60000

interest = $ 1500

amount owed = $ 7500 ( as 50% was already kept as margin)

margin kept = $ 7500

Amount invested from her own money = $ 5000

net profit = $ (60000-1500-7500-5000-7500) = $ 38500

a) return on purchase = 38500/(7500+5000) x 100 = 308% (3 X profit !)

b) if she uses her own money instead of margin, the amount invested is $ 20000

return of the Trump transaction = (60000-20000)/20000 x 100 = 200% (2 X profit)

2 a) Trump Enterprises trades at $21 per share at end of year

Net transaction value for buying Trump Enterprises = $20000 (20 x 1000)

Debt Capital = $ 15000 (margin requirement = $7500 interest = $1500 pa)

Investment = $ 5000

Trump Enterprises rises to $21 per share by end of year

Net value = $21 x 1000 = $ 21000

a) interest = $ 1500

amount owed = $ 7500 ( as 50% was already kept as margin)

margin kept = $ 7500

Amount invested from her own money = $ 5000

net profit (or loss) = $ (21000-1500-7500-5000-7500) = - $500

Loss percentage = - 4%

if entire purchase is done on her own money, then returns = (21000-20000)/20000 x 100 = 5%

3 a) Trump Enterprises trades at $15 per share at end of year

Net transaction value for buying Trump Enterprises = $20000 (20 x 1000)

Debt Capital = $ 15000 (margin requirement = $7500 interest = $1500 pa)

Investment = $ 5000

Trump Enterprises rises to $15 per share by end of year

Net value = $15 x 1000 = $ 15000

a) interest = $ 1500

amount owed = $ 7500 ( as 50% was already kept as margin)

margin kept = $ 7500

Amount invested from her own money = $ 5000

net profit (or loss) = $ (15000-1500-7500-5000-7500) = - $6500

Loss percentage = -52%

if entire purchase is done on her own money, then returns = (15000-20000)/20000 x 100 = 25%

4. Risk being calculated as the SD of returns, they are tabulated as:

Scenario 1: Trump trades at $60

Scenario 2: Trump trades at $21

Scenario 3: Trump trades at $15

Hence, it can be concluded than although the returns on borrowed money is significantly higher than that of returns on her own money. the risks are much higher in the first case than the second.