Investments: An Introduction, 11th Edition Herbert B. Mayo solutions manual and test bank

Investments: An Introduction, 11th Edition Herbert B. Mayo solutions manual and test bank

Chapter 2 Securities Markets

TRUE/FALSE

T 1. A major function of organized securities markets is to

facilitate the transfers of securities among investors.

T 2. A “round lot” is the general unit for trading in a security.

T 3. The purchase of 53 shares of IBM is an odd lot.

T 4. If a stock is quoted 20‑20.50, an investor can buy the stock for 20.50.

F 5. If a stock is quoted 12‑13, an investor can sell the

stock for 13.

T 6. The spread between the bid and ask prices should be viewed as one of the costs of investing.

T 7. Market makers guarantee to buy and sell at least one round lot at the prices they quote.

F 8. The level of securities prices is set by market makers.

T 9. The New York Stock Exchange is an example of a secondary market.

T 10. Publicly‑owned stock that is not listed on an exchange

is traded in the over‑the‑counter markets such as the Nasdaq stock market.

F 11. Bid and ask price quotations for over‑the‑counter stocks are available through the NYSE.

F 12. Stockbrokers set bid and ask prices.

F 13. Investors who are "bearish" purchase securities.

F 14. A short sale is a sale that occurs quickly after the

stock is purchased.

F 15. Once a stock has been sold, the investor receives a confirmation specifying the amount to be remitted (i.e., paid).

T 16. Securities must be paid for by the settlement date.

F 17. The margin requirement is set by the SEC.

F 18. The margin requirement sets the maximum cash investment the individual investor must make.

T 19. If the investor buys stock on margin and the price falls, the percentage loss is magnified.

T 20. Once securities are purchased, they may be registered in the brokerage firm's name.

T 21. After purchasing stock, an investor may place a stop loss order to sell if the stock's price declines.

T 22. Selling short is selling borrowed securities.

F 23. Investors are insured against loss from brokerage firm failure by the SEC.

F 24. A short position is premised on securities prices rising.

T 25. U. S. citizens may invest in foreign stocks by

purchasing American Depository Receipts (ADRs).

F 26. ADRs pay dividends in foreign currencies.

T 27. Publicly owned firms must provide investors with information that may affect the value of the firm's securities.

F 28. The purpose of the full disclosure laws is so investors

will not make poor investments.

F 29. The SEC cannot suspend trading in a firm's stock.

T 30. The purpose of the federal securities laws is to provide investors with data and facts so they can make informed investment decisions.

F 31. The Securities Investor Protection Corporation (SIPC)

protects individuals from poor investments.

F 32. The maintenance margin requirement sets the minimum an investor must remit to purchase a stock.

T 33. If an investor buys stock on margin and the price of the stock rises, the investor will not receive a margin call from the broker.

F 34. Sarbanes-Oxley created the Public Company Accounting Oversight Board whose task is to regulate securities prices.

T 35. The passage of Sarbanes-Oxley created a stronger firewall between investment banking activities and the role of financial analysts.

F 36. The primary role of organized securities exchanges is to raise capital (money) for firms.

T 37. A direct transfer of funds from savers to firms occurs when new securities are issued in the primary market.

T 38. The direct sale of new securities to a pension plan is

a private placement, and the securities do not have to be registered with the SEC.

T 39. In an "underwriting" the investment banker guarantees

the firm selling the securities a specified amount of funds.

F 40. In a "best effort" sale of securities, the risk of the

sale rests with the investment banker.

T 41. The syndicate's role in an underwriting is to sell the new issue of securities.

F 42. If the underwriter overprices a new issue, the market price of the securities will rise.

T 43. A prospectus is required when a corporation issues new

securities that are sold to the general public.

T 44. The cost of an underwriting (to the firm issuing the

securities) is the difference between the price of the public and the proceeds received by the firm.

T 45. A new issue of corporate securities sold to the general public must be registered with the SEC.

F 46. The SEC establishes the price of a new stock issue.

F 47. If the price of an initial public offering of stock

rises, the windfall gain goes to the underwriter.

F 48. A "lock-up" refers to a security transaction with an assured profit.

F 49. A shelf-registration involves the selling of new securities without having them registered with the SEC.

MULTIPLE CHOICE

c 1. A broker

a. stresses one type of investment

b. makes a market in securities

c. buys securities for customers' accounts

d. underwrites stock but not corporate bonds

a 2. The spread is the

a. difference between the bid and ask prices

b. commission charged by the broker

c. difference between the purchase and sale prices

d. difference between the commissions charged by full

service and discount brokers

b 3. A market maker

1. sells stock at the ask price

2. buys stock at the ask price

3. sells stock at the bid price

4. buys stock at the bid price

a. 1 and 2

b. 1 and 4

c. 2 and 3

d. 3 and 4

a 4. If the quote on stock is reduced, that implies

1. supply exceeded demand

2. demand exceeded supply

3. the price was too high

4. the price was too low

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

d 5. Daily securities transactions that are reported in

the financial media generally include

1. the volume of transactions

2. the high and low prices for the day

3. the net change in price from the previous day

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

b 6. A registered representative

a. makes a market

b. buys and sells for customers' accounts

c. represents brokerage firms with the NYSE

d. sets the spread

a 7. The cost of investing includes

1. commissions

2. the spread

3. dividends

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

c 8. Investors are insured from brokerage firm losses by

a. the SEC

b. the Federal Reserve

c. the SIPC

d. the FDIC

a 9. Securities regulations protect investors by

a. requiring disclosures of information by firms

b. stopping investors from buying overpriced stock

c. reducing competition among brokers

d. establishing commission schedules

d 10. Inside information

a. is obtained from inside brokerage firms

b. is reported in a firm's financial statements

c. must be disclosed to the SEC

d. may not be legally used to obtain security profits

a 11. If a stock is bought on margin,

a. part of the cost of investment is borrowed

b. the commissions on the investment are increased

c. the cost of the investment is reduced

d. the interest on the borrowed funds is set by the SEC

a 12. The margin requirement is set by the

a. Federal Reserve

b. SEC

c. FDIC

d. SIPC

a 13. Short selling is

a. selling borrowed securities

b. selling stock owned for less than a year

c. selling an odd lot

d. selling against the investor's broker's advice

c 14. American Depository Receipts represent

a. American stocks traded abroad

b. European stock traded in Europe

c. foreign stocks traded in the U.S.

d. American and foreign stocks traded OTC

d 15. Short selling requires

1. no collateral

2. a margin payment

3. delivering securities owned

4. borrowing securities to deliver

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

b 16. Profits will result from a short sale if

a. stock prices rise

b. stock prices fall

c. stock prices remain stable

d. answer is indeterminate

c 17. The value of an ADR will tend to increase if

1. the value of the dollar rises

2. the value of the dollar falls

3. foreign stock markets rise

4. foreign stock markets fall

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

a 18. The Sarbanes-Oxley law

a. reduces potential conflicts of between securities

analysts and investment bankers

b. legalizes the sale of securities by investment

bankers

c. requires corporate boards of directors to own stock

d. mandates that securities analysts file their

recommendations with the SEC.

c 19. Which of the following is not part of the underwriting

process?

a. the prospectus

b. the originating house

c. the SIPC

d. the SEC

a 20. The syndicate

1. facilitates the sale of new securities

2. is formed by the originating house

3. creates a secondary market in stocks

a. 1 and 2

b. 1 and 3

c. 2 and 3

d. all of the above

a 21. If the initial offer price of a new issue is too low,

1. demand will exceed supply

2. supply will exceed demand

3. the price of the securities will rise

4. the price of the securities will fall

a. 1 and 3

b. 1 and 4

c. 2 and 3

d. 2 and 4

c 22. The final prospectus does not include

a. the firm's balance sheet

b. the price of the securities sold to the public

c. the underwriter's profit on the sale

d. the underwriting discount

a 23. A new issue of corporate securities sold to the general

public must be

a. registered with the SEC

b. initially sold through brokers

c. offered initially to existing stockholders

d. bought by specialists in corporate securities

c 24. Concerning a new issue of stock, a lock-up refers to

a. a guaranteed profit on the initial purchase

b. a guaranteed profit to the underwriter

c. the requirement that shares purchased by

insiders prior to an initial public offering

must retain those shares for a specified period

d. initial buyers of the stock in the IPO must

hold the shares for a specified period of time

PROBLEMS

1. An investor purchased on margin Orange Computer for $30 a share. The stock's price subsequently increased to $50 a share at which time the investor sold the stock. If the margin requirement is 60 percent and the interest rate on borrowed funds was 7 percent, what would be the percentage earned on the investor's funds (excluding commissions)? What would have been the return if the investor had not bought the stock on margin?

2. An investor bought on margin 100 shares of Copier Corp. for $85 a share. The firm paid an annual dividend of $4 a share; the margin requirement was 60 percent with an interest rate of 8 percent on borrowed funds, and commissions on the purchase and sale were $75. The price of the stock rose to $120 in one year.

a. What is the percentage earned on the investment if the stock is bought for cash (i.e., the investor did not use margin)?

b. What is the percentage earned on the investment if the stock is bought on margin?

3. An investor sells 100 shares short at $43. The sale requires a margin deposit equal to 60 percent of the proceeds of the sale. If the investor closes the position at $49, what was the percentage earned or lost on the investment? If the position had been closed when the price of the stock was $27, what would have been the percent earned or lost on the position?

4. An investor sells 100 shares short at $43. The sale requires a margin deposit equal to 60 percent of the proceeds of the sale. The company paid a cash dividend of $2 per share. If the investor closed the position at $36, what was the percentage earned or lost on the investment?

SOLUTIONS TO PROBLEMS

1. Cost of the stock: $30

Margin requirement: (.6)($30) = $18

Amount borrowed: $30 - $18 = $12

Percentage return when the investor used margin:

Profit on the trade = Sale - Cost - Interest

= $50 - $30 - .07($12) = $19.16

Percentage earned on the investor's funds:

$19.16/$18 = 106.4%

Percentage return when the investor did not use margin:

Profit in the trade = $50 - $30 = $20

Percentage earned on the investor's funds: $20/$30 = 66.7%.

2. a. Profit = Cash inflow - Cash outflow

= Sale - Commissions - (Cost + Commissions) + Dividends

= $12,000 - $75 - ($8,500 + $75) + $400 = $1,750

Percentage earned on investor's funds:

$3,750/$8,075 = 46.44%

b. Margin required: (.6)($8,500 + $75) = $5,145

Amount borrowed: (.4)($8,500 + $75) = $3,430

Interest cost: (.08)($3,430) = $274.40

Profit = Sale - Commissions - (Cost + Commissions)

+ Dividends - Interest

= $12,000 - $75 - ($8,500 + $75) + $400 - $274.40

= $3,475.60

Percentage earned on investor's funds:

$3,475.60/$5,145 = 67.55%

3. Proceeds of the sale $43 X 100 = $4,300

Margin requirement: .6 x $4,300 = $2,580

When the price of the stock rises to $49, the investor loses $600 ($4,300 - $4,900). The percentage lost on the invested funds is

($600)/$2,580 = (23.2%).

When the price of the stock falls to $27, the investor earns a profit of $1,600 ($4,300 - $2,700). The percentage return is

$1,600/$2,580 = 62.0%.

These percentage returns do not consider (1) commissions, (2) any interest if the investor borrowed the funds to meet the margin requirement, and (3) any dividends the short seller must pay to the investor from whom the shares were borrowed.

4. This problem repeats the previous problems and adds a dividend payment that the short seller must cover.

Proceeds of the sale $43 X 100 = $4,300

Margin requirement: .6 x $4,300 = $2,580

When the price of the stock falls to $36, the investor earns a profit of $700 ($4,300 - $3,600). However, the short seller must cover the $2 dividend, so the net gain is $500 ($700 - $200 = $500). The percentage return is $500/$2,580 = 19.4%.

 

CHAPTER 2

SECURITIES MARKETS

Teaching Guides for Questions and Problems in the Text

QUESTIONS

1. a. Listed securities are traded through a formal exchange such as the New York Stock Exchange. The securities of unlisted firms are traded over‑the‑counter market. The primary OTC market is the Nasdaq stock market. There is also an OTC market for smaller and less actively traded stocks (such as the "pink sheets"). The investor may obtain quotes and executions as rapidly for Nasdaq and other OTC stocks as for listed securities.

b. Market makers (i.e., securities dealers) offer to buy and sell securities at prices they quote (i.e., the bid and ask). They maintain markets in securities (stocks or bonds). Their sources of profit are (1) the difference between the price at which they buy and the price at which they sell (i.e., the spread between the bid and ask), (2) interest and dividend income received on the inventory of securities they own, and (3) price appreciation in the value of their inventory of securities.

Brokers are agents who buy and sell securities for their customers’ accounts. Brokers earn income through commissions from executing transactions.

c. Full-service broker firms offer more services such as financial planning while discount and electronic brokerage firms’ primary role is to execute trades. The commissions charged by full-service brokerage firms are perceptibly higher than those charged by discount and electronic brokerage firms.

d. The primary market is the initial sale of a security such as the “initial public offering” of a stock. Proceeds of the sales go to the firm issuing the security. All subsequent transactions are in the secondary market in which proceeds flow form the buyer to the seller.

e. A market order is an order to buy or sell at the current price. In many cases that order will be executed at the current bid or ask prices. However, the instructor should point out that prices can and do change rapidly, and could change between the time the market order is given and executed. In addition, the investor may not be able to buy or sell the entire order at the current bid or ask price.

A good‑till‑canceled order is a buy or sell order at a specific price. It remains in effect until it is either executed or canceled. Since the price of the stock may never reach the specified price, there is no assurance the order will be executed.

f. With a cash account, all transactions are settled with the buyer’s funds. The buyer pays the full price of the security plus the commissions. With a margin account, the investor may borrow some of the funds necessary to pay for the security purchase (i.e., buying securities with an initial

cash payment plus borrowed funds). The instructor should point out that having a margin account does not require that the investor use margin and borrow part of the cost of the security. A margin account gives the investor the option to use borrowed funds but does not require the investor to borrow the funds.

2. A stop‑loss order is placed after the investor takes a position in a security. The order seeks to limit the investor's potential loss from a price movement in the wrong direction. For example, if an investor buys a stock for $20, that individual may place a stop‑loss order to sell at $16 and thus avoid letting the price decline to $12. Once the price declines to the specified price, the order becomes a market order and is executed.

3. The use of margin means the individual commits fewer of his or her funds than would be required for a cash purchase. This use of financial leverage increases the potential percentage return on the investor's funds if the price of the stock rises but correspondingly increases the potential percentage loss if the price falls.

4. a. Investors sell short in anticipation of a decline in a stock's price.

b. The short seller borrows the stock (through the broker) and sells it in anticipation of buying it back after the price has declined.

c. A short position is closed when the short seller purchases the security and returns it to the lender.

d. If the price does decline, the short seller profits because the shares are purchased for a lower price than they were sold. The investor makes a profit by buying low and selling high, but with a short sale the sale occurs first.

e. The risk from a short position is the fact that the price could rise instead of falling, in which case the short seller has to buy the stock at a higher price. As always, investors make profits by buying at one price and selling for a higher price.

5. FDIC insures depositors with funds in commercial banks and other depository institutions up to some specified limit (currently $250,000) against loss from failure by the bank. SIPC is designed to protect investors from the failure of brokerage firms and insures investors up to $500,000 from loss resulting from failure by a brokerage firm.

The primary purpose of the federal securities laws is to provide investors with sufficient information so they can make informed investment decisions. The laws require full and timely disclosure of any information that may affect the value of a firm's securities. While these laws provide investors with access to information, they do not guarantee that the investor will make wise decisions.

The role of the Securities and Exchange Commission (SEC) is to enforce the federal securities laws. The SEC seeks to protect investors by assuring the timely release of information and from loss due to illegal use of inside information and fraud in the firm's financial statements. This is achieved by having publicly owned firms file quarterly reports and annual reports (respectively the 10‑Q and 10‑K reports) and by requiring these firms to disclose information that may affect the value of the firm's securities. The SEC has the power to suspend trading in a security if the firm does not publicly disclose the required information.

6. a. The role of the investment banker is to sell either new issues or privately held securities (i.e., a secondary sale of privately held securities) to the general public. Investment bankers also sell securities in private placements.

b. The syndicate is a selling group formed by the lead investment banker(s) to facilitate the sale of stocks and bonds (i.e., the securities being issued).

c. The preliminary prospectus is registered with the SEC to inform the public of the securities and of the firm issuing the securities. It includes such information as the firm's financial statements, the use of the proceeds of the sale, which comprises the firm's management, and legal proceedings involving the firm. The final prospectus repeats this information with any updates and changes required by the SEC. This document is provided to each person who acquires the newly issued securities.

d. The Securities and Exchange Commission (SEC) is the federal agency that oversees the federal security laws. All publicly held corporate securities must be registered with the SEC, except small issues being sold in only one state which must be registered with that state's regulatory body. The SEC determines if the information is sufficient to meet the full disclosure laws. Only after this determination has been made may the securities be sold to the general public.

7. In an underwriting, the investment banker guarantees the

firm issuing the securities a specified amount of money (i.e., the investment banker buys the securities at a specified price). These funds must be delivered by the investment bankers even if they are subsequently unable to sell the securities to the public. Thus, with an underwriting, the risk associated with the sale rests with the investment bankers who will sustain a loss if the securities are unsold.

This loss occurs either through a price reduction, which is necessary to move the unsold securities, or through borrowing the money to pay for the securities acquired from the issuing firm. Borrowing funds to cover the unsold securities involves interest expense, which reduces the profit margin from the underwriting.

In a “best effort” agreement for the sale of securities, the risk rests with the firm issuing the securities. The investment banker agrees to make the best effort but does not guarantee the sale (i.e., does not buy the securities). If the securities are overpriced and do not sell, then the firm seeking the money will not receive the desired funds. Thus, the risk associated with the failure to sell the securities rests with the firm issuing the securities and not with the investment banker.

8. Investors buy new issues for the anticipated return, which is some cases has been substantial. Since all publicly held firms had to sell securities initially, the investor may be buying today the shares of tomorrow's success story (e.g., Google).

The risk associated with investing in the shares of an unseasoned firm is that many new firms do not succeed. However, some firms do exceptionally well and over a period of time prove to have been excellent investors. (You may wish to ask your students what they think is the probability of selecting one of these firms before it achieves that success.)

Ask Jeeves and Ariba illustrate IPOs whose prices rose and subsequently declined dramatically. Investor A purchased 100 shares of Ariba at the IPO price ($28.24); investor B bought during the first day of trading ($69). Investor C bought after three months ($151). The cost of the 100 shares to each of the three investors is

Investor A $2,824

Investor B $6,900

Investor C $15,100.

Each investor profited, but if each of these investors held the positions, they subsequently sustained a large loss on the investment. Ariba closed at $1.27 ($7.74 after adjusting for a 1 for 6 stock split) at the end of 2006, so the 100 shares were worth $127. In July 2009, the stock was trading for about $9. Even if the students do adjust for the reverse split, investors A, B, and C sustained losses if they continued to hold the shares. (Since stocks splits are not covered until the chapters on stock, there is no reason to assume they would adjust for the split.)

The winners were those individuals who sold out to the investors who held on. (Point out that this is essentially a zero sum game and that the Internet bubble of 1999-2000 caused a transfer of wealth from those who thought stock prices would rise indefinitely to those who cashed out.)

9. The prices of IPOs are often volatile which receives initial publicity, especially if the price rises. Many initial high flyers subsequently do poorly. This question asks students to determined what happened to several stocks after their initial public offering. I particularly like using Vonage as an illustration. After going public at $17 in 2006, the stock traded for $8.50 one month later and continued to decline. The stock was trading for $6.50 after three months, and after a year the stock was trading for about $3. Six years after the IPO, Vonage was trading between $3 and $1.50.

The subsequent prices after the IPOs:

Groupon Zyngra Facebook

One month $17.50 $9.41 $27.49

Six months 10.71 5.44 21.71

One year 4.15 2.55 NA

Two years not available when text went to press

10. The question requests that students track the price of an IPO for a period of time to determine what happened after the initial sale. The ability to use this exercise will depend on the amount of activity in the IPO markets.

PROBLEMS

1. Gain on the stock: $1,750 ‑ $1,000 = $750

Margin Requirement Margin Return on Investor's

Funds

25% $250 $750/$250 = 300%

50% $500 $750/$500 = 150%

75% $750 $750/$750 = 100%

2. Loss on the stock: $750 ‑ $1,000 = ($250)

Margin Requirement Margin Return on Investor's

Funds

25% $250 ‑$250/$250 = ‑100%

50% $500 ‑$250/$500 = ‑50%

75% $750 ‑$250/$750 = ‑33.3%

The generalization implied by problems 1 and 2 is that if the margin requirement is small (e.g., 25 percent), then the potential return or loss on the investor's funds (i.e., the margin) is magnified for a given change in the stock's price.

3. Cost of 100 shares: $10,000

a. profit on the stock: $11,200 - $10,000 = $1,200

percentage return (100% cash) $1,200/$10,000 = 12%

b. loss on the stock: $9,000 - $10,000 = ($1,000)

percentage loss: (40% cash) ($1,000)/$4,000 = -25%

c. loss on the stock: $6,000 - $10,000 = ($4,000)

percentage loss: (40% cash) ($4,000)/$4,000 = -100%

4. This problem adds the interest that must be paid on the borrowed funds.

a. The cost of the shares is 100 x $35 = $3,500.

Investor pays for the investment with cash and has

no interest expense.

b. Investor B borrows $3,500 x 0.4 = $1,400 and has

interest expense of $1,400 x 0.08 = $112.

c. The capital gain for both investors is

$4,000 - $3,500 = $500

The percentage return for investor A is

$500/$3,500 = 14.3%

The percentage return for investor B is

($500 – 112)/($3,500 – 1,400) = $388/$2,100 = 18.5%

d. The percentage returns differ because investor A

borrowed 40 percent of the cost of the investment.

Even though that investor paid interest, the use of

financial leverage successfully increased the

percentage return.

5. This is a much more comprehensive problem that considers not only the change in the security's price but also commissions, dividends received, and interest on any loans resulting from buying the stock on margin. The instructor may wish to work through an example of the holding period return that encompasses dividends received, commissions paid, and any interest paid on a margin account before assigning this problem.

Determination of the amount invested and the amount borrowed (margin requirement = 60 percent):

Cash Account Margin Account

Cost of the stock $5,500 $5,500

Commissions 110 110

Funds invested by 5,610 .6(5,610) = 3,366

the individual

Funds borrowed ‑‑ 2,244

Percentage return on invested funds if the price of the

stock is $40:

Cash Account Margin Account

Proceeds of sale $4,000 $4,000

Commissions 80 80

Net proceeds 3,920 3,920

Dividends received 500 500

Interest paid ‑‑‑ .10(2,244) = 224

Capital loss (1,690) (1,690)

(3,920 ‑ 5,610)

Percentage loss on $-1,690 + 500 $-1,690 + 500 ‑ 224

investor's funds $5,610 $3,366

= ‑21.2% = ‑42.0%

In this illustration the use of leverage (i.e., the buying of stock on margin) magnifies the percentage loss on the investor's funds.

Percentage return on invested funds if the price of the

stock is $55:

Cash Account Margin Account

Proceeds of sale $5,500 $5,500

Commissions 110 110

Net proceeds 5,390 5,390

Dividends received 500 500

Interest paid ‑‑‑ .10(2,244) = 224

Capital loss (220) (220)

(5,390 ‑ 5,610)

Percentage loss on $-220 + 500 $-220 + 500 ‑ 224

investor's funds $5,610 $3,366

= 5.0% = 1.7%

Percentage return on invested funds if the price of the

stock is $60:

Cash Account Margin Account

Proceeds of sale $6,000 $6,000

Commissions 120 120

Net proceeds 5,880 5,880

Dividends received 500 500

Interest paid ‑‑‑ .10(2,244) = 224

Capital gain 270 270

(5,880 ‑ 5,610)

Percentage gain on $270 + 500 $270 + 500 ‑ 224

investor's funds $5,610 $3,366

= 13.7% = 16.2%

Percentage return on invested funds if the price of the

stock is $70:

Cash Account Margin Account

Proceeds of sale $7,000 $7,000

Commissions 140 140

Net proceeds 6,860 6,860

Dividends received 500 500

Interest paid ‑‑‑ .10(2,244) = 224

Capital gain 1,250 1,250

(6,860 ‑ 5,610)

Percentage gain on $1,250 + 500 $1,250 + 500 ‑ 224

investor's funds $5,610 $3,366

= 31.2% = 45.3%

Determination of the amount invested and the amount borrowed (margin requirement = 40 percent):

Cash Account Margin Account

Cost of the stock $5,500 $5,500

Commissions 110 110

Funds invested by 5,610 .4(5,610) = 2,244

the individual

Funds borrowed ‑‑ 3,366

Percentage return on invested funds if the price of the

stock is $40:

Cash Account Margin Account

Proceeds of sale $4,000 $4,000

Commissions 80 80

Net proceeds 3,920 3,920

Dividends received 500 500

Interest paid ‑‑‑ .10(3,366) = 337

Capital loss (1,690) (1,690)

(3,920 ‑ 5,610)

Percentage loss on $‑1,690 + 500 $‑1,690 + 500 ‑ 337

investor's funds $5,610 $2,244

= ‑21.2% = ‑68.0%

Percentage return on invested funds if the price of the

stock is $55:

Cash Account Margin Account

Proceeds of sale $5,500 $5,500

Commissions 110 110

Net proceeds 5,390 5,390

Dividends received 500 500

Interest paid ‑‑‑ .10(3,366) = 337

Capital loss (220) (220)

(5,390 ‑ 5,610)

Percentage gain or $‑220 + 500 $‑220 + 500 ‑ 337

loss investor's $5,610 $2,244

funds = 5.0% = ‑2.5%

Percentage return on invested funds if the price of the

stock is $60:

Cash Account Margin Account

Proceeds of sale $6,000 $6,000

Commissions 120 120

Net proceeds 5,880 5,880

Dividends received 500 500

Interest paid ‑‑‑ .10(3,366) = 337

Capital gain 270 270

(5,880 ‑ 5,610)

Percentage gain on $270 + 500 $270 + 500 ‑ 337

investor's funds $5,610 $2,244

= 13.7% = 19.3%

Percentage return on invested funds if the price of the

stock is $70:

Cash Account Margin Account

Proceeds of sale $7,000 $7,000

Commissions 140 140

Net proceeds 6,860 6,860

Dividends received 500 500

Interest paid ‑‑‑ .10(3,366) = 337

Capital gain 1,250 1,250

(6,860 ‑ 5,610)

Percentage gain on $1,250 + 500 $1,250 + 500 ‑ 337

investor's funds $5,610 $2,244

= 31.2% = 63.0%

Summary:

Price of the Percentage return:

stock Cash Margin: 60% 40%

$40 ‑21.2% ‑42.0% ‑68.0%

55 5.0 1.7 ‑2.5

60 13.7 16.2 19.3

70 31.2 45.3 63.0

This problem illustrates the use of margin including commissions, dividends, and interest paid on by the funds borrowed when margin is used. If security prices rise, the potential return is increased on the investor's funds when the stock is bought on margin. Correspondingly, if security prices fall, the percentage loss is increased. The magnification is greater when the margin requirement is smaller since the investor is able to borrow more funds to purchase the stock.

Also notice that the use of margin does not start to magnify the positive return until the price of the stock has risen sufficiently to offset the interest expense before the impact of levering the position is felt. (Make certain that the student realizes that the absolute amount of the capital gain or loss is not affected by the margin requirement. The impact is on the return on the investor's funds which depends not only on the capital gain but also the interest paid to finance the position and the amount of funds the investor has to commit to the position.)

6. The next three problems are concerned with selling short. Short sellers must put up collateral, so the percentage returns depend on the amount of cash the short seller must commit. In this problem, the collateral is 100 percent of the value of the stock sold short ($4 per share).

a. If the stock’s price doubles to $8, the loss on the position is $4 and percentage loss is ($4)/$4 = (100%). The short seller loses the entire collateral.

b. If the stock’s price rises to $10, the loss on the position is $6 and percentage loss is ($6)/$4 = (150%). The short seller loses more than the original collateral and would be required to remit additional funds as the price of the stock rises.

c. If the price of the stock goes to $0, the gain is $4 and the percentage gain is $4/$4 = 100%.

d. The best return the short seller can earn is 100 percent and for that to happen the price of the stock must decline to $0. There is no limit to the potential percentage loss on the short sale.

e. Obviously having the stock go to $0 is the best case scenario. The worse case occurs as the price of the stock rises, and there no limit to the potential loss on the short sale. (Margin requirements and margin calls that occur as the price of the stock rises limit the investor’s potential loss.)

7. If an investor sells a stock short at $36 and the margin requirement is 60 percent, the investor must deposit $21.60 (.6 x $36) with the broker. If the stock subsequently falls to $30, the investor earns a profit of $6 ($36 ‑ 30). The percent earned on the investor's funds is $6/$21.60 = 27.8%

If the price of the stock rises to $42, the investor sustains a loss of $6 ($36 ‑ 42). The percentage of the investor's funds that is lost is ‑$6/$21.60 = ‑27.8%

Notice that this problem does not consider brokerage fees and dividend payments (for which the short seller is responsible). In addition, the percentage earned or lost is not the rate of return except in the case that the holding period is one year.

8. In this problem the investor sells the stock short at $50 and covers the short at $42, so there is an $8 gain on the transaction. The short seller, however, is responsible for the $2 dividend, so the net gain on the transaction is $6. The percentage return is $6/$50 = 12%.

Teaching Guides for Financial Advisors Investment Case: INVESTING AN INHERITANCE

OBJECTIVE: Comparing buying stock with cash to acquiring stock using margin.

BACKGROUND: This case considers two individuals with different proclivities towards bearing risk. Both individuals will receive an inheritance of $85,000. Other considerations such as employment, income, participation in pension plans and medical insurance are similar for both individuals so that the emphasis may be placed on the impact of a risky versus a less risky strategy is isolated.

TEACHING GUIDES FOR THE QUESTIONS

1. Darin:

Cash required for purchase: $6,000 + 70 = $6,070

Dividend received: $150

Interest paid: $0

Proceeds from sale: $8,000 - 70 = $7,930

Profits from sale: $7,930 - 6,070 = $1,860

Percentage earned: ($1,860 + 150)/$6,070 = 33.1%

2. Victor:

Cash required for purchase: ($6,000 + 70)0.6 = $3,642

Amount borrowed: $6,070 - 3,642 = $2,428

Dividend received: $150

Interest paid (0.07 X $2,428): $169.96

Proceeds from sale: $8,000 - 70 = $7,930

Profits from sale: $7,930 - 6,070 = $1,860

Percentage earned: ($1,860 + 150 - 169.96)/$3,642 = 50.5%

Buying the stock on margin and using borrowed funds

may increase the percentage return.

3. If the sale price were $50, the percentage returns are

Darin:

Cash required for purchase: $6,000 + 70 = $6,070

Dividend received: $150

Interest paid: $0

Proceeds from sale: $5,000 - 70 = $4,930

Loss from sale: $4,930 - 6,070 = -$1,140

Percentage loss: (-$1,140 + 150)/$6,070 = -16.3%

Victor:

Cash required for purchase: ($6,000 + 70)0.6 = $3,642

Amount borrowed: $6,070 - 3,642 = $2,428

Dividend received: $150

Interest paid (0.07 X $2,428): $169.96

Proceeds from sale: $5,000 - 70 = $4,930

Loss from sale: $4,930 - 6,070 = -$1,140

Percentage loss: (-$1,140 + 150 - 169.96)/$3,642 = -31.8%

If the sale price were $100, the percentage returns are

Darin:

Cash required for purchase: $6,000 + 70 = $6,070

Dividend received: $150

Interest paid: $0

Proceeds from sale: $10,000 - 70 = $9,930

Gain from sale: $9,930 - 6,070 = $3,860

Percentage gain: ($3,860 + 150)/$6,070 = 66.1%

Victor:

Cash required for purchase: ($6,000 + 70)0.6 = $3,642

Amount borrowed: $6,070 - 3,642 = $2,428

Dividend received: $150

Interest paid (0.07 X $2,428): $169.96

Proceeds from sale: $10,000 - 70 = $9,930

Gain from sale: $9,930 - 6,070 = $3,860

Percentage gain:

($3,860 + 150 - 169.96)/$3,642 = 105.4%

4. Since Darin only uses cash, he may take delivery. Victor, however, must leave the stock with the broker as collateral for the loan. Even though Darin may take delivery, there are advantages associated with leaving the securities registered with the broker, the primary one being convenience. Since the brokerage firm is insured by SIPC, there is no additional risk associated with leaving the securities in street name.

5. An increase in the interest rate charged by the broker would have no impact on Darin's return, since he has not borrowed funds to acquire the stock. Victor's return would be reduced as he would have to pay more interest expense to carry the securities.

6. Maintenance margin only applies to stock purchased on margin, so it would have no affect on Darin's position. Victor, however, is using margin, and if the price of the stock decline sufficiently, the maintenance margin requirement would require that he deposit additional cash or securities with the broker. The price of the stock that will result in a margin call is

0.3 = (100 X P) - $2,428

100 X P

P = $2,428/70 = $34.69.

An alternative calculation is P = $24.28/.7 = $34.69.

If the price of the stock is $50, the decline is insufficient to generate a margin call.

7. If you anticipate that Darin will acquire a low yielding savings account, there is an argument that he should buy stock. Since his general financial condition is secure, he is capable of bearing additional risk in order to earn a higher return. As is discussed later in the text, the historical returns on stocks over an extended period of time exceed other traditional investments. (You may use this question as a means to introduce historical returns on various alternative investments.)

Victor's financial condition is the same a Darin, but he is likely to purchase extremely risky investments or squander the money. As with Darin, buying stock also makes sense, but if Victor needs additional risk and higher potential return, they may be achieved by acquiring the stock of margin.

For either individual, acquiring stock is probably a better alternative than a very low risk, low return strategy or a very high risk, high return strategy, especially if the latter results in the individual not investing but perhaps gambling away the funds.