Question

An investor recently opened a brokerage account with $400,000 of cash. They decide to purchase shares of NewCorp (NEWC). Prescribing to the philosophy of “go big or go home,” the investor decides to utilize the full margin borrowing capacity available through their broker. The investor may borrow from their broker at 8% per year and must have an initial margin of at least 50%. The maintenance margin is 25%. The current market price of NEWC is $160.00.

a. Assume the investor utilizes their maximum margin potential. How many shares of NEWC can the investor purchase? b. [4] Below what stock price will the investor receive a margin call?

c. If the investor holds this position for 3 months and then sells the shares and repays the loan, what is the percentage profit (loss) if the market price of NEWC is $210.00 after 3 months?

d. If the investor holds this position for 3 months and then sells the shares and repays the loan, what is the percentage profit (loss) if the market price of NEWC is $110 after 3 months?

e. Compare your answers in C. and D. to the profit (loss) if the investor did not use the margin account and instead only purchased $400,000 worth of NEWC shares. Discuss the effect of leverage on returns.

Answer 1

A)How many shares of NEWC can the investor purchase

initial deposit = $400,000 i.e 50%

margin provided by borker $400,000 50%

total value = cash deposit + margin provided by borker

= $400,000+ $400,000

=$800,000

no of share purchased = investment value / share price

=$800,000/$160

=5000 shares

b. [4] Below what stock price will the investor receive a margin call?

investment value =$800,000

maintanence marigin = investment value * margin percentage

=$800,000*25%

=$200,000

per share =$ 200,000/5000

40

if share price falls to (160-40) 120 he will recieve margin call

c) share price after 3 months is 210

buying price =160

selling price 210

profit = selling price- buying price

=210-160= 50

total profit = no of shares * profit per share

=50*5000=$250,000

net proft = total profit - interest on margin @8%

=$250,000-4000,000*8%*3/12

=$250,000- $8,000

=$242,000

return in percentage = net profit / cash deposit

(242,000/400,000)*100

=60.5%

d)if share price is 110

buying price =160

selling price 110

profit = selling price- buying price

=110-160= -50

total loss= no of shares * profit per share

=-50*5000= -$250,000

net proft = total profit - interest on margin @8%

=-$250,000-4000,000*8%*3/12

=-$250,000- $8,000

-$258,000

return in percentage = net profit / cash deposit

(282,000/400,000)*100

=-64.5%( loss)

e)f the investor did not use the margin account

no of shares purchases =400,000/160

2500

if share price 210

profit =(210-160)*2500 =125,000

%= 125000/400,000= 31.25%

if share price 110

profit =(110-160)*2500 =-125,000

%= -125000/400,000= -31.25%

effect on leverage  

if share price is up you wll get more return

if share is down you will have to bare more loss than without leverage i.e. without margin