Andre Khan is a stockbroker who lives with his wife, Sasha, and their five children in Milwaukee, Wisconsin. Andre firmly believes that the only way to make money in the market is to follow an aggressive investment posture - for example, to use margin trading. In fact, Andre himself has built a substantial margin account over the years. He currently holds $75,000 worth of stock in his margin account, though the debit balance in the account amounts to only $30,000. Recently, Andre uncovered a stock that, on the basis of extensive analysis, he feels is about to take off.
The stock, Running Shoes (RS), currently trades at $20 per share. Andre feels it should soar to at least $50 within a year. RS pays no dividends, the prevailing initial margin requirement is 50%, and margin loans are now carrying an annual interest charge of 10%. Because Andre feels so strongly about RS, he wants to do some pyramiding by using his margin account to purchase 1,000 shares of the stock.
a. What is the present margin position (in percent) of Andre's account?
b. Andre buys the 1,000 shares of RS through his margin account (bear in mind that this is a $20,000 transaction).
i. What will the margin position of the account be after the RS transaction if Andre follows prevailing initial margin (50%) and uses $10,000 of his money to buy the stock?
ii. What if he uses only $2,500 equity and obtains a margin loan for the balance ($17,500)?
iii. How do you explain the fact that the stock can be purchased with only 12.5% margin when the prevailing initial margin requirement is 50%?
c. Assume that Andre buys 1,000 shares of RS stock at $20 per share with a minimum cash investment of $2,500 and that the stock does take off and its price rises to $40 per share in 1 year.
i. What is the return on invested capital for this transaction.
ii. What return would Andre have earned if he had bought the stock without margin - that is, if he had used all his own money?
The Solution explains earning higher income by using borrowed funds to purchase securities.