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Investments: tax free vs taxable; margin call; return risk

1. Suppose your tax bracket is 20%. Would you prefer to earn a 8% taxable return or a 6% tax-free return? What is the equivalent taxable yield of the 6% tax-free return?

2. Suppose that HP is currently selling at $25 per share. You buy 500 shares using $7,500 of your own money and borrowing the remainder of the purchase price from your broker. The rate on the margin loan is 6%. If the maintenance margin is 25%, how low can HP's price fall before you get a margin call?

a. What is the expected return of a stock given the following information:
State of Probability Return
Economy

Good .1 15%
Normal .6 13
Poor .3 7

b. What is the standard deviation of returns?

3. A stock has a beta of 1.5, the risk free rate is 6% and the expected market return is 12%. What is the required rate of return using the CAPM model? If the expected return for the stock is 14.5%, would you recommend purchasing the shares now? Explain your answer in detail.

Solution Preview

1. Suppose your tax bracket is 20%. Would you prefer to earn an 8% taxable return or a 6% tax-free return? What is the equivalent taxable yield of the 6% tax-free return?
To choose we should compare the post tax return on the two investments.
On taxable instrument the post tax return is =pre tax return*(1-Tax rate) =8%*(1-20%)=6.4%
On tax free instrument the post tax return is same as pre tax return =6%
Since post tax return is higher on 8% taxable instrument, invest in this instrument.
Equivalent taxable yield on 6% tax free ...

Solution Summary

Answers four problems on rate of return under different economic scenarios, risk, capital asset pricing model and capital structuring. Could be used as a good practice for exams.

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