Question 1
Multiple ChoiceAn investor purchases 500 shares of a non-dividend paying stock on margin and sells them after one year under the following terms:
Purchase price per share: $40
Sale price per share: $30
Annual interest rate on borrowed funds: 6%
Leverage ratio: 1.5
Ignoring commissions and taxes, the investor's holding period return is closest to:
Explanation
Let’s walk through the holding period return calculation step-by-step:
1. Total Purchase Cost
500 shares × $40 = $20,000
2. Leverage Ratio
A leverage ratio of 1.5 means the investor contributed 1/1.5 = 2/3 of the total cost as equity.
Equity = 2/3 × $20,000 = $13,333.33
Borrowed = $20,000 – $13,333.33 = $6,666.67
3. Interest on Borrowed Amount
6% × $6,666.67 = $400
4. Sale Proceeds After One Year
500 shares × $30 = $15,000
5. Net Return to Investor
Sale Proceeds = $15,000
Minus Original Purchase = –$20,000
Minus Interest = –$400
→ Net Profit = $15,000 – $20,000 – $400 = –$5,400
6. Return on Equity (Holding Period Return)
= –$5,400 / $13,333.33 = –0.405 or –40.5%, which is closest to –38%