Question

INSTRUCTIONS: SUBMIT SOFT COPY OF YOUR ANSWERS ON MOODLE

CASE STUDY

Two of your acquaintances (Mercy and Dennis) approach you seeking investment advice. Each of them had K100 000 of savings to invest. Both invested in LSK Ltd shares which were trading at K20 per share. Mercy used her entire savings to purchase LSK Ltd shares. Dennis felt that LSK Ltd shares would perform well so he approached a broker and took up a margin transaction with a 55% initial requirement. The broker charged Dennis 10% annual interest, and commissions of 3% of the total stock value on both the purchase and sale. The dividend at the end of year was K0.50 per share and the shares trade at K27 at the end of the year.

Required:  

1. How many shares did Mercy buy?

2. How many shares did Dennis buy?

3. Calculate Mercy’s percentage return on investment.                           

4. Calculate Dennis’s percentage return on investment.                      

5. Who made a better investment decision?                                               

                                   

Answer 1

a. Mercy bought: K100000/20= 5,000 shares of LSK Ltd.

b. Dennis had a total of K 100 000 savings to invest. And he got a margin of from his broker at an initial 55% requirement. Therefor Dennis can purchase shares of value= 100 000/55%= K181 818. This means Dennis can purchase 181818/20 shares. Thus, he owns 9090 shares of LSK Ltd.  

c. The return on Investment of Mercy is:

((0.5+(27-20))*5000)/100000= 37500/100000

= 37.5%

d. Dennis earned the following:

=(4545+63630-8181-5454-7363)/100000= 47177/100000

= 47.177%

Working Notes:

i. Dividend Income: 9090*0.5= K 4 545

ii. Increase in share price= (27-20)*9090= K 63 630

Charges charged by the Broker:

iii. Annual Interest: 81810*10%= K 8181

Amount Borrowed= 9090*20*45%= K 81 810

iv. Commission on Purchase= 9090*20*3%= K 5 454

v. Commission on sales (Since the shares are held with broker the same needs to be sold) = 9090*27*3%= K7 363

e. As the return on the investment for the same amount of K 100 000, Dennis earned the return of 47.17% as compared to 37.5% of Mercy thus Dennis made a better decision as with the margin available he was able to purchase more shares.