Question

Consider a stock priced at $40 per share that pays an annual dividend of $1.0. An investor buys the shares on margin, paying $20 per share and borrowing the remainder from the brokerage firm at an 6% annual interest rate.  After one year, the stock is sold for $50 per share. Because the shares were purchased on margin, the return on the stock is _____.  However, if the investor had purchased the shares for 100% cash, the stock return would have been _____.

A. 25.0%; 49.0%

B. 55.0%; 27.5%

C. 49.0%; 27.5%

D. 50.0%; 25.0%

Answer 1

An investor pays $20 and borrows remaining $20.

After a year, investor has to pay interest = $20 x 6% = $1.2

what he earned in a year = sale price + dividend - purchase price - interest paid

what he earned in a year = 50 + 1 - 40 - 1.2 = 9.8

so return on share using margin money = 9.8/20 *100 = 49%

In case, if he has purchased for cash

what he earned in a year = sale price + dividend - purchase price

what he earned in a year = 50 + 1 - 40= 11

so return on share using own money (cash) = 11/40 *100 = 27.5%

correct answer : C : 49%, 27.5%