Chartered Financial Analyst Level 1

Chartered Financial Analyst Level 1

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An investor purchases 1,000 shares of a non-dividend paying stock on margin and sells them after one year. Given the following details:

  • Purchase price per share: $25
  • Sale price per share: $20
  • Annual call money rate: 5%
  • Leverage ratio: 2 Ignoring commissions, the investor's holding period return is closest to:

Explanation:

Explanation

The correct answer is A (-45%) because it accurately reflects the return on investment for the investor, considering the leverage and cost of borrowing.

  1. Total Purchase Price: 25/share×1,000shares=25/share × 1,000 shares = 25,000.
  2. Leverage Ratio of 2: Indicates the buyer's equity is half of the total purchase price.
    • Buyer's equity = 1/2 × 25,000=25,000 = 12,500.
    • Borrowed amount = 25,000−25,000 - 12,500 = $12,500.
  3. Interest on Borrowed Money: 5% × 12,500=12,500 = 625.
  4. Sale Proceeds: 20/share×1,000shares=20/share × 1,000 shares = 20,000.
  5. Net Return to Buyer: Sale proceeds - Purchase price - Interest payment = 20,000−20,000 - 25,000 - 625=−625 = -5,625.
  6. Return on Investment: -5,625/5,625 / 12,500 = -45%.

Why not B or C?

  • B (-40%) is incorrect because it ignores the cost of borrowing.
  • C (-23%) is incorrect because it calculates the return on the total purchase value without considering leverage.
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