You have just learned about the mechanics of margin trading and want to take advantage of the potential benefits of financial leverage. You have decided to open a margin account with your broker and to secure a margin loan. The specifics of the account are as follows:

• Initial margin requirement is 70%.

• Maintenance margin is 30%.

• You are informed that if the value of your account falls below the maintenance margin, your account will be subject to a margin call.

You have been following the price movements of a stock over the past year and believe that it is currently undervalued and that the price will rise in the near future. You feel that opening a margin account is a good investment strategy. You have decided to purchase three round lots (i.e., 300 shares) of the stock at its current price of $25 per share.

Create a spreadsheet similar to the spreadsheet for Table 2.3, which can be viewed at http://www.myfinancelab.com, to model and analyze the following market transactions.

Questions

a. Calculate the value of your investment in the stock if you did not make use of margin trading.
In other words, how much must you invest if you fund your purchase with 100% cash equity?

b. Calculate the debit balance and the cash equity in the investment at the time of opening a margin account, adhering to the initial margin requirement.

c. If you use margin and the price of the stock rises by $15 to $40/share, calculate the capital gain earned and the return on investor’s equity.

d. What is the current margin percentage based on item c?

e. If you use margin and the price of the stock falls by $15 to $10/share, calculate the capital loss and the respective return on investor’s equity.

f. What is the new margin percentage based on item e, and what is the implication for you, the investor?

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TABLE 2.3 THE EFFECT OF MARGIN TRADING ON SECURITY RETURNS With Margins of Without Margin (100% Equity) 80% 65% 50% Number of $50 shares purchased 100 100 100 100 Cost of investment $5,000 $5,000 $5,000 $5,000 Less: Borrowed money -$ 0 -$1,000 -$1,750 -$2,500 Equity in investment $5,000 $4,000 $3,250 $2,500 A. Investor's position if price rises by $30 to $80/share Value of stock $8,000 $8,000 $8,000 $8,000 Less: Cost of investment -$5,000 -$5,000 -$5,000 -$5,000 Capital gain $3,000 $3,000 $3,000 $3,000 Return on investor's equity (capital 60% 75% 92.3% 120% gain/equity in investment) B. Investor's position if price falls by $30 to $20/share Value of stock $2,000 $2,000 $2,000 $2,000 Less: Cost of investment -$5,000 -$5,000 -$5,000 -$5,000 Capital loss* -$3,000 -$3,000 -$3,000 -$3,000 Return on investor's equity (capital (60%) (75%) (92.3%) (120%) loss/equity in investment)* *Both the capital loss and the return on investor's equity are negative, as noted by the parentheses.