QUESTION

# Ravi Dumar is a stockbroker

Short Paper

Ravi Dumar is a stockbroker who lives with his wife, Sasha, and their five children in Milwaukee, Wisconsin. Ravi 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, Ravi has built himself 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 Ravi 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. Ravi 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 Ravi feels so strongly about RS, he wants to does some pyramiding by using his margin account to purchase 1,000 shares of the stock.

Questions:

Discuss the concept of pyramiding as it applies to this investment situation.     What is the present margin position (in percent) of Ravi’s account?     Ravi buys the 1,000 shares of RS through his margin account (bear in mind that this is a $20,000 transaction). What will the margin position of the account be after the RS transaction if Ravi follows the prevailing initial margin (50%) and uses$10,000 of his money to buy the stock? What if he uses only $2,500 equity and obtains a margin loan for the balance ($17,500)?  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%?   Assume that Ravi 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. What is the return on invested capital for this transaction? What return would Ravi have earned if he had bought the stock without margin—that is, if he had used all his own money? What do you think of Ravi’s idea to pyramid? What are the risks and rewards of this strategy? Excel with Spreadsheets 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 the opening of a margin account is a good investment strategy. You have decided to purchase 3 round lots (i.e., 100 shares per round lot) 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 view below at to model and analyze the following market transactions.

Questions:

Calculate the value of the investment in the stock if you did not make use of margin trading. In other words, what is the value of the investment if it is funded by 100% cash equity? 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. 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. What is the current margin percentage based on question c? 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. What is the new margin percentage based on question e, and what is the implication for you, the investor?

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 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 gain/equity in investment)

60%

75%

92.3%

120%

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 loss/equity in investment) (60%) (75%) (92.3%) (120%) *Both the capital loss and the return on investor’s equity are negative, as noted by the parentheses • Elite2 249 orders completed$25.00