Assume that the stock of Warner-Lambert Company, a pharmaceutical manufacturer, is currently selling for $75 per share. You have $7,500 of your own funds to invest. The brokerage firm that you use for your stock trades will allow you to borrow funds to buy the stock with an initial margin equal to 62.5 percent, a maintenance margin of 40 percent, and a broker loan rate equal to 12 percent. In one year, you expect the per-share price of Warner-Lambert’s stock to be 20 percent higher than it is today. At that time, the company will pay shareholders a cash dividend equal to $2.00 per share.
a. If your expectations for the coming year are correct, what return would you earn if you invested your $7,500 and did not borrow any funds from the brokerage firm?
b. If you borrowed the maximum amount allowable from the brokerage firm, how much can you invest in Warner-Lambert?
c. If your expectations for the coming year are correct, what return would you earn if you invested your $7,500 and borrowed the maximum funds allowable from the brokerage firm?
d. Compute the return that you would earn if the stock’s price drops to $70 per share at the end of the year and you borrowed to invest the maximum amount possible to purchase the stock at the beginning of the year.