Question

You decide to purchase 7,000 Cobtom shares at $6.50 each using a 40% margin loan. Over the next year the price of the shares goes up to $8.40 each, and you receive dividends of $0.40 per share. The interest rate on the margin loan is 10% pa payable annually.

a How much equity have you initially invested?

b How much have you borrowed?

c What is the new value of the holding at the end of the year?

d What is your total profit in dollar terms?

e What is your annual rate of return on invested capital?

Answer 1

a), Solution :- Initial investment amount = 7000 * 6.50 * (1 - 0.40)

= 45500 * 0.60

= $ 27,300.

Conclusion :- Initial investment = $ 27,300.

b). Solution :- Amount borrowed = 7000 * 6.50 * 0.40

= 45500 * 0.40

= $ 18,200.

Conclusion :- Amount borrowed = $ 18,200.

c). Solution ;- Holding value at the year end = 7000 * 8.40

= $ 58,800.

Conclusion :- Holding value of shares at the year end = $ 58,800.

d). Solution :- Calculation of total profit :-

= (Total amount received on shares including dividend - Total cost incurred on shares including interest on loan)

= [ (7000 * 8.40 + 7000 * 0.40) - (7000 * 6.50 + 10 % of 18,200) ]

= [ (58800 + 2800) - (45500 + 1820) ]

= 61600 - 47320

= $ 14,280.

Conclusion :- Total profit = $ 14,280.

e). Solution :- Return on invested capital = Total profit / Initially invested amount

= 14280 / 27300

= 0.5231 i.e., 52.31 % (0.5231 * 100)

Conclusion :- Return on invested capital = 52.31 % (approx).