Answered: Explain the pros and cons of making…

Pfin (with Mindtap, 1 Term Printed Access Card) (mindtap Course List)

7th Edition

ISBN:9780357033609

Author:Randall Billingsley, Lawrence J. Gitman, Michael D. Joehnk

Publisher:Randall Billingsley, Lawrence J. Gitman, Michael D. Joehnk

Chapter12: Investing In Stocks And Bonds

Section: Chapter Questions

Problem 1FPE: What makes for a good investment? Use the approximate yield formula or a financial calculator to...

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1. Explain the pros and cons of making investment on margin (e.g. buying stocks on margin). Use a numerical example to support your answer.

2. You are positive (or bullish) on a biotech stock. The current market price of this stock is US$50 per share and you have US$5,000 on hand for investment. You borrow another US$5,000 from the broker at an interest rate of 8% per year so that you have a total sum of US$10,000 to invest in the stock.

a. What is your rate of return from this stock if the share price rises by 10% in the next year, assuming this stock pays zero dividend and the transaction cost is zero ?

b. How far does the price of this biotech stock have to fall so that you will receive a margin call from your broker if the maintenance margin is 30% ? Assume the price fall happens immediately.

3. You are considering to invest in a mutual fund with a 4% load and an expense ratio of 0.5%. Alternative, you may invest in a bank certificate of deposit (CD) paying 6% interest.

a. If you plan to invest for 2 years, what annual rate of return must the mutual fund earn so that the result will be better than making investment in the CD ? Assume annual compounding of returns.

b. How does your answer change if you plan to invest for 6 years ?

c. Now suppose that instead of a front-end load, the mutual fund charges a fee of 0.75% per year. What annual rate of return must the mutual fund earn so that the result will be better than making investment in the CD ? Does your answer in this case depend on your time horizon ?

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