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CHAPTER

Answers to Problems

1(a). Assume you pay cash for the stock: Number of shares you could purchase = $40,000/$80
= 500 shares.

(1) If the stock is later sold at $100 a share, the total shares proceeds would be $100 x
500 shares = $50,000. Therefore, the rate of return from investing in the stock is
as follows:

$50,000  $40,000
  25.00%
$40,000

(2) If stock is later sold at $40 a share, the total shares proceeds would be $40 x $500
shares = $20,000. Therefore, the rate of return from investing in the stock would
be:

$20,000  $40,000
  50.00%
$40,000

1(b). Assuming you use the maximum amount of leverage in buying the stock, the leverage
factor for a 60 percent margin requirement is = 1/percentage margin requirement = 1/.60
= 5/3. Thus, the rate of return on the stock if it is later sold at $100 a share = 25.00% x
5/3 = 41.67%. In contrast, the rate of return on the stock if it is sold for $40 a share:
= -50.00% x 5/3 = -83.33%.

2(a). Since the margin is 40 percent and Lauren currently has $50,000 on deposit in her margin
account, if Lauren uses the maximum allowable margin her $50,000 deposit must
represent 40% of her total investment. Thus, $50,000 = .4x then x = $125,000. Since the
shares are priced at $35 each, Lauren can purchase $125,000 – $35 = 3,571 shares
(rounded).

2(b). Total Profit = Total Return - Total Investment

(1) If stock rises to $45/share, Lauren’s total return is:
3,571 shares x $45 = $160,695.
Total profit = $160,695 - $125,000 = $35,695

(2) If stock falls to $25/share, Lauren’s total return is:

3,571 shares x $25 = $89,275.
Total loss = $89,275 - $125,000 = -$35,725.
2(c)

Market Value - Debit Balance

Margin 
Market Value
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where Market Value = Price per share x Number of shares.

Initial Loan Value = Total Investment - Initial Margin.

= $125,000 - $50,000 = $75,000

Therefore, if maintenance margin is 30 percent:

(3,571 shares x Price) - $75,000

.30 
(3,571 shares x Price

.30 (3,571 x Price) = (3,571 x Price) - $75,000.

1,071.3 x Price = (3,571 x Price) - $75,000
-2,499.7 x Price = -$75,000
Price = $30.00
3. Profit = Ending Value - Beginning Value + Dividends - Transaction Costs - Interest
Beginning Value of Investment = $20 x 100 shares = $2,000
Your Investment = margin requirement + commission.
= (.55 x $2,000) + (.03 x $2,000)
= $1,100 + $60
= $1,160
Ending Value of Investment = $27 x 100 shares
= $2,700

Dividends = $.50 x 100 shares = $50.00

Transaction Costs = (.03 x $2,000) + (.03 x $2,700)

(Commission) = $60 + $81
= $141
Interest = .10 x (.45 x $2,000) = $90.00

Therefore:

Profit = $2,700 - $2,000 + $50 - $141 - $90

= $519

The rate of return on your investment of $1,160 is:

$519/$1,160 = 44.74%

4. Profit on a Short Sale = Begin.Value - Ending Value - Dividends -Trans. Costs - Interest

Beginning Value of Investment = $56.00 x 100 shares = $5,600

(sold under a short sale arrangement)

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Your investment = margin requirement + commission

= (.45 x $5,600) + $155
= $2,520 + $155
= $2,675

Ending Value of Investment = $45.00 x 100 = $4,500

(Cost of closing out position)

Dividends = $2.50 x 100 shares = $250.00

Transaction Costs = $155 + $145 = $300.00

Interest = .08 x (.55 x $5,600) = $246.40

Therefore:

Profit = $5,600 - $4,500 - $250 - $300 - $246.40

= $303.60

The rate of return on your investment of $2,675 is:

$303.60/$2,675 = 11.35%

5(a). I am satisfied with the profit resulting from the sale of the 200 shares at $40.

5(b). With the stop loss: ($40 - $25)/$25 = 60%

Without the stop loss: ($30 - $25)/$25 = 20%

6(a). Assuming that you pay cash for the stock:

($45 x 300) - ($30 x 300) 13,500 - 9000

Rate of Return    50%
($30 x 300) 9000
6(b). Assuming that you used the maximum leverage in buying the stock, the leverage factor
for a 60 percent margin requirement is = 1/margin requirement = 1/.60 = 1.67. Thus, the
rate of return on the stock if it is later sold at $45 a share = 50% x 1.67 = 83.33%.

7. Limit order @ $24: When market declined to $20, your limit order was executed $24
(buy), then the price went to $36.
Rate of return = ($36 - $24)/$24 = 50%.

Assuming market order @ $28: Buy at $28, price goes to $36

Rate of return = ($36 - $28)/$28 = 28.57%.

Limit order @ $18: Since the market did not decline to $18 (lowest price was $20) the
limit order was never executed.

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