FIN3244 FINAL
Describe how, if at all, conservative and aggressive investors might use each of the following types of transactions as part of their investment programs. Contrast these two types of investors in view of these preferences. a. Long purchase b. Margin trading c. Short selling
(a) Long purchases are typically used by more conservative investors. They are most able to ride-out negative market conditions and are betting with general, long-term market trends (up). (b) Margin trading is typically used by aggressive investors seeking short-term capital appreciation (increase in value). (c) Short selling is typically used by aggressive investors seeking short-term profits from falling security prices. They are betting against long-term market trends.
You place a limit order to buy 100 shares of ABC at $38 a share. The stock is currently selling for $41. Discuss the consequences of each of the following: (a) The stock price drops to $39 per share two months before the limit order expires. (b) The stock price drops to $38 per share. (c) The minimum stock price achieved before the limit order expires was $38.50. Following the order expiration, the stock rose to $47.50 per share.
(a) The stock price drops to $39 per share two months before the limit order expires. The order will not execute. The limit order will only execute if the stock can be bought for $38 or less. However, since there are two months remaining before the limit order expires, it's still possible that the order could execute if conditions are met. (b) The stock price drops to $38 per share. At a price of $38 per share, your broker will buy 100 shares of ABC stock at a total cost of $3,800. This assumes that the stock price doesn't rise above $38 before your order can execute. Orders with higher precedence levels can delay your purchase during which time the price could rise above $38. Should this happen, you will 'miss the market.' (c) The minimum stock price achieved before the limit order expires was $38.50. Following the order expiration, the stock rose to $47.50 per share. This example illustrates that limit orders can prevent transactions from occurring. Since the price didn't go below $38.50, the limit order expired without being executed. If you had bought the stock at $41 instead of placing a limit order, you might have sold the stock for $47.50 per share, thereby, realizing a profit of $650 (100 shares x $6.50 profit per share). Instead, your order wasn't executed and you made nothing.
What is a long purchase? What expectation underlies such a purchase? What is margin trading. What is the main reason that investors sometimes use it when making long purchases?
A 'long' purchase occurs when an investor buys a security in the hope that it will increase in price and can be sold at a later time for a profit. The long purchase is the most common type of transaction. Its returns are the result of dividends or interest paid to the security holder and capital gains or losses (the difference between the purchase price and the sale price.) Trading on margin involves buying securities partly with borrowed funds. Investors use margin to lower the amount of their own money involved in investments. This allows the investor to buy more securities than he otherwise could have. Using borrowed money creates leverage which magnifies both gains and losses. When an investor sells his investment, the proceeds first pay-off the loan (plus interest) and any remaining profits belong to the investor. Buying on margin, however, is risky since the investor can lose more money than he initially invested.
What is common stock? What is meant by the statement that holders of common stock are the residual owners of the firm?
A common stock is an equity investment that represents fractional ownership in a firm. It lets investors participate in the firm's profits. As residual owners of the company, common stockholders are entitled to dividend income (if paid) and a prorated share of the firm's earnings after all other obligations of the firm have been met (liabilities). Investors have no guarantee that they will ever receive any return on their investment.
Differentiate among market orders, limit orders, and stop orders. What is the rationale for using a stop order rather than a limit order?
A market order is an order to buy or sell a security at the best price available at the time the order is placed. It's the quickest way to make security transactions. A limit order is an order to buy stock at or below a specified price or to sell stock at or above a specified price. It's best used when securities prices are fluctuating within a trading range. A stop order is a suspended order to buy or sell stock. When the stock's price reaches or passes through some specified price (the stop price), the suspended order is activated as a market order. This order is used primarily by investors wanting to protect themselves from rapid stock price declines. When the stop price is reached, the automatic order execution limits how far the stock's price can move against the investor. Thus, the stop order reduces potential losses.
What is a stock split? How does it affect the market value of a stock share? How do you think the stock price would be affected? Explain.
A stock split occurs when a firm announces its intention to increase the number of common shares of stock outstanding by exchanging a specified number of new shares for each existing share. Stock splits are executed to lower the price per share of a stock. This may enhance the stock's trading appeal (Trading Range Theory) since it makes stock shares more affordable to small investors while also lessening the likelihood that they will view the stock as overpriced due simply to a higher cost per share. Stock splits can also send a message (Signaling Theory) to the market that the firm believes its stock is undervalued. This is because stock splits are attention-getting events in the business world and often result in the re-examination of a firm. Stock prices fall proportionately to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. Stock splits are viewed positively by the market. Studies show that despite stock splits being merely cosmetic (no value change), on average, firms that split their shares tend to have abnormal returns for the following year.
What is the difference between a cash dividend and a dividend paid-in-stock? Which would be more valuable to you? How does a dividend paid-in-stock compare to a stock split? Explain.
Cash dividends are simply dividend payments made to stockholders in the form of cash. They are a return to owners of part of the firm's profits. Cash dividends represent something of value since shareholders physically receive cash although the price of stock falls by the dividend amount on the ex-dividend day. A dividend paid-in-stock is the distribution of additional shares expressed and distributed as a percentage of each shareholder's existing shares. As with cash dividends, the market responds to these dividends by adjusting the market stock price accordingly. As an example, a stock trading at $50 per share that declares a 10% dividend paid-in-stock would drop its stock price to $45.45 ($50/1.10). Thus, an investor holding 100 shares before the stock dividend would hold 110 shares afterward. But, the total market value of these shares would be the same, assuming all other things remain equal: $50 100 = $45.45 110. Dividends paid-in-stock substitute for cash dividends. In both instances, when dividends are paid, the firm's stock price adjusts downward proportionately so that the market value of the firm doesn't change. Shareholders, however, typically view cash dividends and dividends paid-in-stock differently. Shareholders may wonder why dividends aren't paid in cash. Those who bought the firm for current income may be negatively impacted by not receiving expected cash payments. If these concerns cause selling pressure on the firm's shares, the firm's stock price may drop by more than the dividend payout. With a cash dividend, the investor actually receives spendable cash. With a dividend paid-in-stock, the investor receives more of what he already owns. Cash dividends may be considered by investors to have greater value. Stock splits occur when a firm exchanges new shares for existing shares owned. In essence, dividends paid-in-stock are a form of stock split, but they are viewed differently by the market. Stock splits are considered positive events whereas dividends paid-in-stock may cause investor concern. Stock splits tend to raise investors' expectations of future firm profits resulting in abnormal returns for stock-splitting firms.
What is day trading. Why is it risky?
Day trading is a trading strategy that involves extremely short-term trading. True day traders don't hold any stock positions overnight. The strategy uses high-risk methodologies that often include margin and short-sale transactions that can end in total loss. Additionally, day traders have high transaction costs for such things as brokerage commissions, training, and computer equipment. Several important factors should be considered before trading securities. First, know how to place and confirm orders before you begin trading. Second, verify the stock symbol of the security you wish to buy. Third, don't ignore online reminders asking you to check and recheck. Fourth, don't get carried away. Many investors designate a fixed amount of capital for purely speculative purposes that they can afford to lose. In this way, they don't jeopardize their financial well-being if they suffer heavy losses.
How important are dividends as a source of return to common stock? What about capital gains? Which is more important to total return? Which causes wider swings in total return?
Dividends are an important source of return to stockholders even though they don't have the "bang" of capital gains. Dividend returns are never negative, although they can be zero. Capital gains have ranged from -27.57% (1974) to +38.32% (1975). Despite capital gains unquestionably providing higher returns than dividends, capital gains are responsible for the wide swings in year-to-year total stock returns. Dividends, in contrast, provide an element of stability and tend to shore-up returns in off-years.
What are dividend reinvestment plans and what benefits do they offer investors? Are there disadvantages?
Firms with dividend reinvestment plans (DRIPs) allow shareholders to automatically reinvest their dividends into additional firm shares. DRIPs provide investors with a convenient and inexpensive way to accumulate stock shares without paying brokerage commissions. Dividends paid into DRIPs, however, are taxed as ordinary personal income in the year received; just as if they'd been received as cash. Since cash dividends reinvested to buy stock shares are stock, their ultimate value depends on a changing stock price. With time, reinvested dividends can be worth more or less than the original cash value of the dividends. When dividends are received in cash, the investor has actual cash-in-hand.
Why do most income stocks offer only limited capital gains potential? Does this mean that the outlook for continued profitability is also limited? Explain.
Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends and re-invest less of their earnings into the finance growth of the firm. Returns from income stocks come mostly from current income rather than capital gains. This does not mean that these stocks are unprofitable. Most, in fact, are highly profitable and have excellent long-term future prospects.
What is the primary motive for short selling? Describe the basic short-sale procedure. Why does the short seller make an initial equity deposit? What do margin requirements have to do with the short-selling process?
Investors who attempt to profit by short selling, intend to 'sell high and buy low.' This is the reverse order of the usual (long purchase) transaction. The investor borrows shares and sells them, hoping to buy them back at a later time at a lower price. The shares are then returned to the lender when purchased. Short sales are regulated by the SEC. Equity capital must be deposited with the brokerage house by the short seller. The amount is the same as the broker's initial margin requirements. This margin and the proceeds of the short sale provide the broker with assurance that the securities can be repurchased at a later date even if prices rise. If stock prices rise high enough to reduce the short seller's margin to the maintenance level, he typically receives a margin call. The short seller can either deposit more equity capital to raise the margin level back to the required level or repurchase the borrowed shares (called 'covering' a short sale.)
Name some of the more important attributes of common stock.
One important attribute of common stock is that it lets investors participate in a firm's profits, thus offering them the possibility of attractive return opportunities. Another attribute of stock is its versatility. It can be used to meet different investment objectives. Relative to many investments, common stock is fairly simple and straightforward, making it easier to understand. Note: this does NOT mean that stock is easy to value. Stocks tend to be liquid, making it easy to buy and sell them. Their transaction costs are modest. Moreover, price and market information concerning firms is widely disseminated in the news and by the financial media.
Not long ago, Jack bought 200 shares of Almost Anything Inc. at $45 per share. He made the purchase on a margin of 60%. The stock is now trading at $60 per share and his brokerage house has recently lowered initial margin requirements to 50%. Jack now wants to do some pyramiding and buy another 300 shares of stock. What is the minimum amount of equity that he has to put up in this transaction?
Securities' price = $45 x 200 shares = $9,000 Equity = $9,000 x .6 = $5,400 Debit = (1 - .6) = .4 x $9,000 = $3,600 New securities' price = $60 x 200 shares = $12,000 (for existing shares) If Jack buys another 300 shares at $60, it will add a total of $18,000 of value to his account. New securities' value = $18,000 (new shares) + $12,000 (old shares) =$30,000 Margin = (Value - Debit balance)/Value .50 = ($30,000 - Debit balance)/$30,000 Minimal new equity = $15,000; maximum debit balance = $15,000 Current debt is $3,600; Amount of additional debit Jack can borrow is: $15,000 - 3,600 = $11,400 Since he needs $18,000 for the additional purchase ($60 x 300 shares) and can only borrow $11,400, he must add the remainder in equity. He needs to add: $18,000 - $11,400 = $6,600 in new equity
An investor purchased 100 shares of Can'tWin.com for $50 per share using as little of his own money as he could. His broker has a 50% initial margin requirement and a 30% maintenance margin requirement. The price of the stock falls to $30 per share. What is the minimum amount of money the investor needs to add to his account? Why?
Securities' price = $50 x 100 shares = $5000 Initial Margin = Equity = $5000 x .5 = $2500; Debit = $5000 - 2500 = $2500 New securities' value = $30 x 100 = $3000 Margin = (Value - Debit balance)/Value New Margin = ($3000 - $2500)/$3000 = $500/$3000 = 16. 7% margin Since 16.7% margin is below the needed 30% maintenance margin, the investor must add equity to his account. Assuming that he will add cash, what is the minimum he can add? Margin = (Value - Debit balance)/Value; given the current securities' value: .30 = ($3000 - D)/$3000 $900 = $3000 - Debit balance Debit balance = $2100; given his investment value $2100 is the largest debt balance he can carry. The problem is that he has debt of $2500. To lower the amount of his debit balance to the maintenance margin level, he must add the difference: $2500 - $2100 = $400 to his account.
Jerri bought 100 shares of a stock at $80 per share using an initial margin of 60%. Given a maintenance margin of 25%, how far does the stock have to drop before Jerri faces a margin call? (Assume no other securities in the margin account.)
Securities' price = $80 x 100 shares = $8,000 Debit = (1 - .6) = .4 x $8,000 = $3200 Margin = (Value - Debit balance)/Value .25 = (Value - $3,200)/Value .25value = 1value - $3,200 $3,200 = .75value; $3,200/.75 = $4267 (this is the total value of 100 shares) $4,267/100 = $42.67; This is the dollar value per share when then margin falls to 25%. This is when you'll get a margin call.
You've been watching a stock that currently trades at $50 per share. You'd buy it if it were less expensive, say $47 per share. You think that by year-end, the stock will go to $70 and then level off or decline. You place a limit order to buy 100 shares at $47 and a limit order to sell at $70. It turns out that you were right about the direction of the price move and it goes straight to $75 without first falling in price. What is your position
Since the stock never fell to the limit order buy price, you never purchased it. However, if you're in a margin account, you sold it at $70 per share, so you are now short 100 shares. Because the stock is currently selling for $75, your current position is a loss of $500.
What is a spin-off? In general terms, explain how a spin-off works. Are these spin-offs of value to investors? Explain.
Stock spin-offs involve the conversion of a firm's subsidiary or division to a stand-alone company by distributing stock in the new company to existing shareholders. For example, PepsiCo spun off its restaurant operations—Pizza Hut, KFC, and Taco Bell—into a new company called Tricon Global Restaurants (now called Yum Brands). Investors keep shares in their old firm while being given shares in the new firm. Investors are free to keep shares of both firms, sell both firms, or sell one of the firms and keep the other.
What protection does the Securities Investor Protection Corporation (SIPC) provide to investors?
The Securities Investor Protection Corporation (SIPC), a nonprofit membership corporation, is authorized to protect customer accounts against the financial failure of brokerage firms. It does NOT protect investors against investment losses. SIPC only insures that stock certificates held in 'street name' are credited to the investor. Only ownership of the shares, themselves, are insured; not their price.
Briefly explain how the dividend decision is made. What corporate and market factors are important in deciding whether, and in what amount, to pay dividends?
The amount of dividends to be paid is decided by the firm's board of directors. The directors evaluate the firm's operational and financial conditions in determining whether dividends should be paid and, if so, in what amount. A variety of factors are incorporated into the board's final decision. These include: (a) The firm's current earnings or profits. (b) The firm's growth prospects. Firms with good investment opportunities tend to retain their earnings to use for new investments and, thus, tend to pay little, if any, dividends. (c) The firm's cash position. The board tries to insure that the firm has sufficient liquidity to meet a cash dividend of a given size. (d) All legal and contractual constraints imposed by loans (Conditions and amounts of dividend payment can be restricted by debt contracts.) (e) The dividend expectations of its shareholders. Failure to meet these expectations can lead to disastrous results in the stock market.
Why is the ex-dividend date important to stockholders? If a stock is sold on the ex-dividend date, who receives the dividend - the buyer or the seller? Explain
The ex-dividend date (which occurs two or three business days prior to the date of record) determines who is eligible to receive the declared dividend. If a stock is sold on or after the ex-dividend date, and before or on the date of record, the previous owner (the seller) receives the declared dividend. If the stock is sold prior to the ex-dividend date, the new shareholder (buyer) receives the declared dividend. Going "ex-dividend" means the buyer is not entitled to the dividend since the stock is being sold "without" it.
What are some of the advantages and disadvantages of owning common stock? What are the major types of risk to which stockholders are exposed?
The major advantage of common stock ownership is the returns it offers. Because stockholders are entitled to participate in the prosperity of a firm, capital gains have unlimited potential. In addition, many stocks provide regular current income in the form of annual dividends. For most income-producing stocks, dividends tend to grow over time, further increasing a stockholder's return. Listed common stocks are also highly liquid and easily transferable. Their transaction costs are relatively low, market information is readily available, and the price per share is typically within reach of small (retail) investors. The risky nature of common stocks is the most significant disadvantage of ownership. As residual owners of the firm, returns are not guaranteed and debt holders have first claim to a firm's assets. Furthermore, stock prices are subject to wide swings that make valuation difficult. Finally, the sacrifice of current income by stockholders is a disadvantage relative to other investments [debt securities (bonds that pay interest, for instance example.)]
What are the main advantages and disadvantages of short selling?
The major advantage of short selling is the chance to make money when the price of a security falls. The major disadvantage of short selling is the high risk exposure in the face of limited returns and unlimited potential losses. In addition, short sellers are betting against the market and they never earn dividends, but must pay them while the short position remains open.
If you place a stop order to sell at $23 on a stock currently selling for $26.50 per share, what is your likely minimum loss on 50 shares if the stock price rapidly declines to $20.50 per share?
The minimum loss you would experience in this case is $3.50 per share or $175 on the total investment (50 shares at $3.50 per share). It's important to realize that this is a minimum loss. This is because when the stock price falls to $23, the stop order is converted to a market order to sell at the best price available price at that time. It's possible that the actual stock price could plunge further. If that happened, the stock would sell below $23 per share (possibly as low as $20.50 in this example). Your loss could be as high as $6/share for a $300 total loss.
Describe the procedures and regulations associated with margin trading. Include an explanation of restricted accounts, maintenance margin, and margin call.
To execute a margin transaction, an investor must establish a margin account. Although the Fed sets the minimum amount of equity for margin transactions, it is not uncommon for brokerage houses to set their own, more restrictive requirements. Once a margin account is established, the investor must provide the minimum amount of required equity at the time of purchase. This is called the initial margin. It is intended to prevent excessive trading and speculation. If the value of the investor's account drops below the initial margin requirement, the investor will have a restricted account and he will be prohibited from making additional purchases in the account without first bringing its equity back to the initial margin requirement. Maintenance margin is the absolute minimum amount of equity that an investor must have in the margin account at all times. If the value of the account drops below the maintenance margin, the investor typically receives a margin call and has a limited time to replenish the equity up to the maintenance margin level. If the investor fails to meet the margin call, the broker can sell the investor's holdings to raise the account margin back to the required level (maintenance margin level.) Margin calls are not required prior to a forced sale. The size of the margin loan is called the debit balance and is used in conjunction with the margined securities value (the collateral) to calculate the value of an investor's margin. Typically, margin is used to magnify returns on a long purchase. When a margin account has more equity than is required by the initial margin, the investor can use this excess margin to buy more securities. This tactic is called pyramiding and takes the concept of magnifying returns to a higher level.
How does margin trading magnify profits and losses? What are the main advantages and disadvantages of margin trading?
When buying on margin, the investor puts up part of the required capital. This is the equity portion of the investment and is the investor's margin. The investor's brokerage house then lends the remaining money necessary to make the transaction. Magnification of profits is the main advantage of margin trading. This is called financial leverage which is created when an investor purchases securities using borrowed funds. Although only a portion of the investment is financed by the investor, he receives all the capital gains (less costs) so the return on the personal funds he invested is magnified. Through leverage, investors can (1) increase the size of their total investment, or (2) purchase additional securities using less of their own funds. Additionally, margin trading can be used to increase diversification or let investors take larger positions in securities they find attractive. The main disadvantage of margin trading is risk. If the investment's price moves against the investor, his losses are magnified. An investor can lose more than his initial investment. Additionally, interest rates on the debit balance can be high and significantly reduce the investor's returns.
You short sell 100 shares of stock for $40 per share. You want to limit your loss on this transaction to no more than $500. What order should you place?
You should place a stop order to buy 100 shares at approximately $45or perhaps a slightly lower price. Since a stop order converts to a market order upon activation, you can't be sure of the exact price at which you'll exit the transaction.
Marlene purchased 300 shares of Writeline Communications stock at $55 per share using the prevailing minimum initial margin requirement of 50%. She held the stock for exactly four months and sold it without any brokerage costs at the end of that period. Complete parts (a) and (b) below. a. Calculate the initial value of the transaction, the debit balance and the equity position on Marlene's transaction. b. For each of the following share prices, calculate the actual margin percentage and indicate whether Marlene's margin account would have excess equity, would be restricted, or would be subject to a margin call.
a. Calculate the initial value of the transaction, the debit balance and the equity position on Marlene's transaction. Securities' price = $55 x 300 shares = $16,500 Equity = $16,500 x .5 = $8,250 Debit = (1 - .5) = .5 x $1,6500 = $8,250 b. For each of the following share prices, calculate the actual margin percentage and indicate whether Marlene's margin account would have excess equity, would be restricted, or would be subject to a margin call. 1. $45 New securities' price = $45 x 300 shares = $13,500 Margin = (Value - Debit balance)/Value Margin = ($13,500 - $8,250)/$13,500 = $5,250/$13,500 = 38.89% Marlene's account is restricted. 2. $70 New securities' price = $70 x 300 shares = $21,000 Margin = (Value - Debit balance)/Value Margin = ($21,000 - $8,250)/$21,000 = $12,750/$21,000 = 60.71% Marlene's account has excess margin. 3. $35 New securities' price = $35 x 300 shares = $10,500 Margin = (Value - Debit balance)/Value Margin = ($10,500 - $8,250)/$10,500 = $2,250/$10,500 = 21.43% Marlene's account is subject to a margin call.
Will owns 200 shares in Riches Firm. The company's board of directors recently declared a cash dividend of $0.50 a share payable April 18th to shareholders of record on March 22nd. (Hint: ex-dividend date is ~ 2 days before.) a. How much in dividends, if any, will Will receive if he sells his stock on March 20th? b. Assume Will decides to hold onto the stock rather than sell it. If he belongs to the company's dividend reinvestment plan, how many new shares of stock will he receive if the stock is currently trading at $40 per share. Will Will have to pay tax on these dividends since he is reinvesting them in stock and will not see any cash payment?
a. How much in dividends, if any, will Wilfred receive if he sells his stock on March 20th? If Wilfred sells his stock on March 20, he will be selling on or after the stock's ex-dividend date and, therefore, he'll be the holder of record on March 22nd. Wilfred is entitled to receive a dividend of $100 ($.50 200 shares). b. Assume Wilfred decides to hold onto the stock rather than sell it. If he belongs to the company's dividend reinvestment plan, how many new shares of stock will he receive if the stock is currently trading at $40 per share. Will Wilfred have to pay tax on these dividends since he is reinvesting them in stock and will not see any cash payment? Wilfred's $100 earned as dividends will go into the firm's DRIP to purchase more shares of the firm's stock. At $40 per share, Wilfred's $100 will buy him 2.5 shares of stock ($100/$40 = 2.5.) Unfortunately, Wilfred will have to pay taxes on the $100 since the IRS says that Wilfred did receive a cash dividend. It was his decision to use it to buy additional stock shares.
On February 29, 2009, GE (General Electric) announced plans to cut its quarterly dividend from $0.31 to $0.10 per share. a. If GE has 10.6 billion shares outstanding, how much cash will GE save each year by cutting the dividend? b. In the 2 days surrounding GE's announcement, its stock fell from $9.03 to $7.54 per share. What is the decline in GE's total market value over this period? c. Does the answer to part 'b' seem appropriate given the answer to part 'a'? Why or why not?
a. If GE has 10.6 billion shares outstanding, how much cash will GE save each year by cutting the dividend? 10.6 billion shares times $0.21 dividend-cut per share times four dividends per year equals $8.9 billion in savings per year. b. In the 2 days surrounding GE's announcement, its stock fell from $9.03 to $7.54 per share. What is the decline in GE's total market value over this period? The stock price dropped $1.49, so with 10.6 billion shares outstanding, GE stock fell by $15.8 billion. c. Does the answer to part 'b' seem appropriate given the answer to part 'a'? Why or why not? The drop in GE's total market value is a little less than twice the amount saved by cutting dividends ($8.9 billion savings versus $15.8 billion drop in market value.) If the price investors were willing to pay for GE stock prior to the dividend cut reflected their expectation that the $0.31 quarterly dividend would continue to be made by the firm, then the market's reaction to this announcement would seem to indicate that investors believe that GE will keep its dividend payments low for a year or two. In other words, investors had been expecting to receive about $8.9 billion more in cash than they will now get after the cut. Since the market price dropped more than this, it likely reflects expectations of more than one year's worth of the lost dividends. The new information investors received (lowered dividend payments) resulted in lower future expectations for GE so its share price dropped. The magnitude of the price drop implies that shareholders currently expect low earnings for a year or two (dividend cash payments come out of earnings.) As more new info is reported about GE, these current expectations will become old and new expectations will form; likely, many times.
An investor owns a stock in XYZ Company. The stock recently underwent a 5:2 stock split. If the stock was trading at $50 per share just before the split, how much will each share sell for after the split, all other things being equal? If the investor owned 200 shares of stock before the split, how many shares will he own afterward?
a. If a $50 stock splits 5:2, the new share price immediately afterward would be $20. $50*(2/5) = $20 b. If an investor owned 200 shares before the split, she would own 500 shares afterward: 200 5/2 = 500 shares c. The market value of her holdings, however, would be unchanged: Before the split: 200 shares $50 = $10,000 After the split: 500 shares $20 = $10,000
Elmo Inc.'s stock is currently selling at $60 per share. For each of the following situations (ignoring transactions costs), calculate the dollar amount of gain or loss an investor realizes if she makes a 100-share transaction. a. She sells short and repurchases the borrowed shares at $70 per share. b. She takes a long position and sells the stock at $75 per share. c. She sells short and repurchases the borrowed shares at $45 per share. d. She takes a long position and sells the stock at $60 per share.
a. She sells short and repurchases the borrowed shares at $70 per share. Securities' price = $60 x 100 shares = $6000 If the investor sells short, her account is credited with $6000. When she repurchases, the securities' price = $70 x 100 = $7,000. $6000 (sell price) - $7000 (buy price) = -$1000. She loses $1000 b. She takes a long position and sells the stock at $75 per share. Securities' price = $60 x 100 shares = $6000 Buy price = $6000 Sell price = $75 x 100 shares = $7500 $7500 (sell price) - $6000 (buy price) = $1500. She gains $1500 c. She sells short and repurchases the borrowed shares at $45 per share. Securities' price = $60 x 100 shares = $6000 Sell price = $6000 Buy price = $45 x 100 shares = $4500 $6000 (sell price) - $4500 (buy price) = $1500. She gains $1500 d. She takes a long position and sells the stock at $60 per share. Securities' price = $60 x 100 shares = $6000 Buy price = $6000 Sell price = $60 x 100 shares = $6000 $6000 (sell price) - $6000 (buy price) = 0. She neither gains nor loses. In reality, there would be commission costs (both when buying and selling) which would cost money and she would lose that amount.
Define and differentiate between the following pairs of terms. a. Treasury stock versus classified stock. b. Par value versus market value. c. Book value versus investment value.
a. Treasury stock versus classified stock. Firms do not "issue" treasury stock; these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm. This is generally done because the firm views the stock (of itself) as an attractive investment. Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions, employee stock option plans, or to pay dividends as stock rather than cash. Treasury stock is not a form of classified stock. 'Classified' stock are groupings of common stock according to different voting rights and/or dividend obligations each group has. For example, Class A stock might designate nonvoting shares that receive higher dividend rates, while Class B stock might designate shares with more votes than other shares. b. Market value. A firm's market value is equal to the number of common shares outstanding multiplied by the price of a stock share. It is literally, the price 'the market' values a firm at, at a specific point in time. The par value is determined by the issuing entity and remains unchanged over time c. Book value versus investment value. Book value is an accounting measure of the amount of stockholder's equity in a firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value indicates what value an investor places on the stock. It is often referred to as a firm's 'intrinsic' value. Investment value is based on expectations of the risk and return. It can vary with different investors since different investors can come to different conclusions about the value of a stock share. It is the maximum price the investor will be willing to pay for the share.
Assume that an investor buys 100 shares of stock at $50 per share, putting up a 60% margin. a. What is the debit balance in this transaction? b. How much equity must the investor provide to make this margin transaction? c. If the stock rises to $60 per share, what is the investor's new margin position?
a. What is the debit balance in this transaction? Securities' price = $50 x 100 shares = $5000 Debit = (1 - .6) = .4; $5000 x .4 = $2000 b. How much equity must the investor provide to make this margin transaction? Margin = .60 x $5000 = $3000 OR $5000 - $2000 = $3000 c. If the stock rises to $60 per share, what is the investor's new margin position? New value = $60 x 100 = $6000 Margin = (Value - Debit balance)/Value Margin = ($6000 - $2000)/$6000 = 66.67%
Assume that an investor buys 100 shares of stock at a $50 per share, putting up 70% margin. a. What is the debit balance in this transaction? b. How much equity must the investor provide to make this margin transaction? c. If the stock rises to $80 per share, what is the investor's new margin position?
a. What is the debit balance in this transaction? Securities' price = $50 x 100 shares = $5000 Debit = (1 - .7) = .3; $5000 x .3 = $1500 b. How much equity must the investor provide to make this margin transaction? Margin = .70 x $5000 = $3500 OR $5000 - $1500 = $3500 c. If the stock rises to $80 per share, what is the investor's new margin position? New value = $80 x 100 = $8000 Margin = (Value - Debit balance)/Value Margin = ($8000 - $1500)/$8000 = $6500/$8000 = 81.25%
