Answer:
a. Rate of return is 12%
Explanation:
a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year?
Initial investment = Personal fund + Borrowed fund
= $5,000 + $5,000 = $10,000
Number of shares purchased = Initial investment ÷ Share price
= $10,000 ÷ $50 = 200 shares
Amount of increase in stock value = $10,000 × 10% = $1,000
Interest paid on borrowed fund = $5,000 × 8% = $400
Rate of return = (Amount of increase in stock value - Interest paid on borrowed fund) ÷ Borrowed fund
Rate of return = ($1,000 - $400) ÷ $5,000
= $600 ÷ $5,000
= 0.12 or 12%
Therefore, the rate of return is 12%
b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%?
Total share value = 200P
Where P denotes the price per share
Equity = Total share value - Borrowed fund = 200P - $5,000
Required/maintenance margin = Equity ÷ Total share value
30% = (200P - $5,000) ÷ 200P
Since 30% = 0.30, we can now solve for P as follows:
0.30 × 200P = 200P - $5,000
60P = 200P - $5,000
200P - 60P = $5,000
140P = $5,000
P = $5,000 ÷ 140
P = $35.71
Therefore, the price of Telecom stock have to fall to $35.71 to receive a margin call if the maintenance margin is 30%.
