Chapter 03 - Participating in the Market

SOLUTIONS MANUAL
CHAPTER 3
PARTICIPATING IN THE MARKET
PROBLEMS
Margin purchase
1. Assume you buy 100 shares of stock at $40 per share on margin (40 percent). If the
price rises to $55 per share, what is your percentage gain on the initial equity?
31.

100$40
Loan
Initial Equity

= $4,000
=-2,400
=$1,600

Price increases:
Loan
Equity (Ending)

$3,100 $1,600 = $1,500 gain

100$55

=$5,500
-2,400
3,100

= 93.75% gain

Margin purchase
2. In problem 1, what would the percentage loss on the initial equity be if the price had
decreased to $28?
3-2.
100$40
Loan
Initial Equity

= $4,000
=-2,400
=$1,600

Price increases:
Loan
Equity (Ending)

$400 $1,600 = -$1,200 loss

100$28

=$2,800
-2,400
400

= 75.00% loss

Minimum margin
3. Assume you have a 25 percent minimum margin standard in problems 1 and 2. With a
price decline to $28, will you be called upon to put up more margin to meet the 25
percent rule? Disregard the $2,000 minimum margin balance requirement.
3-3.

Equity/Market Value = $400/$2,800 = 14.28%

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You are below the 25 percent minimum margin standard and would be
required to increase your equity from $400 to $700 (.25 x $2,800).

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Minimum margin
4. Recompute the answer to problem 3 based on a stock decline to $23.75.
3-4.

First compute the equity position:

100$40
Loan
Initial Equity

= $4,000
=-2,400
=$1,600

Price increases:
Loan
Equity (Ending)

100$23.75

=$2,375
-2,400
-25

You are now wiped out and have lost your total investment. The
broker would have never let you get to this position and would have asked for
more margin (problem 3) but there are times when the stock market or a particular
stock has significant declines in one day.
Selling short
5. You sell 100 shares of Norton Corporation short. The price of the stock is $60 per
share. The margin requirement is 50 percent.
a. How much is your initial margin?
b. If stock goes down to $42, what is your percentage gain or loss on the initial margin
(equity)?
c. If stock goes up to $67.50, what is your percentage gain or loss on the initial margin
(equity)?
d. In part c, if the minimum margin standard is 30 percent, will you be required to put up
more margin? (Do the additional necessary calculations to answer this question.)

3-5.

a)

b)

c)
d)

100 $60
Margin
Initial Margin (equity)

$6, 000
50%
$3, 000

Pr ofit ($60 $42) 100

$1,800

Initial margin (equity)

$3, 000

Loss ($60 $67.50) 100

$ 750

Initial margin (equity)

$3, 000

60% Gain

25% Loss

To answer this question, you must compare the current margin

position to the market value of the stock.

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Chapter 03 - Participating in the Market

Initial margin (equity)

Loss

$3, 000
750

Current margin (equity)

$2, 250

Current margin (equity)

$2, 250

33%

6, 750
You will not be required to put up more margin as 33 percent exceeds 30 percent.
Margin purchase and Selling short
6. You are very optimistic about the personal computer industry, so you buy 200 shares of
Microtech Inc. at $45 per share. You are very pessimistic about the machine tool
industry, so you sell short 300 shares of King Tools Corporation at $55. Each
transaction requires a 40 percent margin balance.
a. What is the initial equity in your account?
b. Assume the price of each stock is as follows for the next three months (month-end).
Compute the equity balance in your account for each month:
Month
October
November
December
3-6.

Microtech Inc.
$51
39
37

King Tools Corp.

$48
62
40

a)

b)

Microtech
Margin
Initial margin (equity)

200$45=$9,000
40%
$3,600

King Tools
Margin
Initial margin (equity)
Total margin (equity)

300$55=$16,500
40%
$6,600
$10,200

Monthly gain or loss in margin and new equity balance.

Microtech
King Tools

October
Gain ($51 $45) 200 $1, 200
Gain ($55 $48) 300 $2,100

Total Gain
$3,300
New equity balance $10,200 + $3,300 = $13,500

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Chapter 03 - Participating in the Market

November
Microtech

Loss ($39 $51) 200 $2, 400

King Tools

Loss ($48 $62) 300 $4, 200

Total Loss
$6, 600
New equity balance $13,500 $6,600 = $6,900

Microtech
King Tools

December
Loss ($37 $39) 200 $400
Gain ($62 $40) 300
6, 600

Net Gain
$6, 200
New equity balance $6,900 + $6,200 = $13,100
Commission percentage
7. Lisa Loeb is considering buying 100 shares of CMA Record Company. The price of the
shares is $52. She has checked around with different types of brokers and has been
given the following commission quotes for the trade: online broker, $7; discount broker,
$45; full-service broker, $98.
a. Compute the percentage commission for all three categories.
b. How many times larger is the percentage commission of the full-service broker
compared with the online broker? Round two places to the right of the decimal point for
this answer.
online broker
$7 / $5, 200
.13%
discount broker
$45 / $5, 200 .87%
3-7. a)
full-sevice broker
$98 / $5, 200 1.88%
b)
c)

full - service broker 1.88%

14.46x
on - line broker
.13%
It is lower than yield to maturity because it does not take into
consideration the fact that the bond price will increase from
$839.27 to $1,000 over the next 15 years. This increases the yield
to maturity.

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Chapter 03 - Participating in the Market

Selling short and capital gains

10. Al Rodriguez sells 500 shares of Gold Mine Corp. short at $80 per share. The margin
requirement is 50 percent. The stock falls to $62 over a three-month time period, and
he closes out his position.
a. How much is his initial margin?
b. What is his percentage gain or loss on his initial margin?
c. If he is in a 35 percent tax bracket for short-term capital gains and a 15 percent bracket
for long-term capital gains, what is his tax obligation?
d. If the stock went up to $94 instead of down to $62, what would be his dollar loss?
e. Assuming this is his only transaction for the year, how large a tax deduction could he
take against other income?
500 shares $80 = $40,000

3-10. a)

b)
c)

d)
e)

Initial Margin (equity) at 50% =$20,000

Pr ofit ($80 $62) 500 $9, 000

45%
Initial margin (equity) 20, 000

Since he only had the position for three months, he must treat the
profit as a short-term capital gain. This means it will be taxed at 35
percent.
Profit
Tax Rate

$9, 000
35%

Tax obligation

$3,150

Loss ($80 - $94) 500 = ($7,000)

The maximum tax write-off in any one year for net investment
losses is $3,000. That is the maximum amount A1 can write off in
the year of the loss.
Side note: the remaining $4,000 can be carried forward into the
future.

Price-weighted average
11. There are three stocks in a price-weighted index:
A
$100
B
20
C
60
a. What is the average value for the index?
b. Assume stock A goes down by 25 percent and stock B goes up by 25 percent, and stock
C remains the same. What is the new average value for the index?
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Chapter 03 - Participating in the Market

c. Explain why in part b the average changed with two stocks moving up and down by the
same percentage amount.
A
$100
B
20
3-11. a.
C
60

b.

A
B
C

$180 3 $60
$100 .75
$ 75
20 1.25
25
60 1.00
60

$160 3 $53.33
c.
The price-weighted average gives a higher weighting to high
priced stocks than to low priced stocks. Thus the 25 percent decline on the
$100 stock had a greater impact than the 25 percent rise on the $20 stock.

Computing an index
12. Assume the following five companies are used in computing an index:

Company
A
B
C
D
E

Shares
Outstanding
6,000
2,000
10,000
1,000
4,000

Base Period
January 1, 1984
Market Price
$6
5
8
20
15

Current Period
December 31, 2007
Market Price
$12
18
40
10
32

a. If the index is price weighted, what will be the value of the index on December 31,
2007? (Take the average price on December 31, 2007, and divide by the average price
on January 1, 1984, and multiply by 100.)
b. If the index is value weighted, what will be the value of the index on December 31,
2007? (Take the total market value on December 31, 2007, and divide by the total
market value on January 1, 1984, and multiply by 100.)
c. Explain why the answer in part b is different from the answer in part a .

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Chapter 03 - Participating in the Market

3.12.

a)
Company
A
B
C
D
E

Base Period Current P eriod

Market Pr ice Market Pr ice
$ 6
5
8
20
15

$ 12
18
40
10
32

$54
$112
$54
$112
Average price
$10.8
$22.4
5
5
$22.4
Index
100 2.07 100 207
$10.8
Alternative Calculation
Index

Company
A
B
C
D
E

$112
100 2.07 100 207
$54

b)
Shares
Outstanding
6,000
2,000
10,000
1,000
4,000

Base Period
Market
Total
Price
Value
6
$36,000
5
10,000
8
80,000
20
20,000
15
60,000
$206,000
$646, 000
Index
100 3.14 100 314
206, 000

Current Period
Market
Total
Price
Value
$12
$72,000
18
36,000
40
400,000
10
10,000
32
128,000
$646,000

c)
Stock C with a fivefold increase in price was heavily weighted in
Part b. Stock D with a 50 percent decline was lightly weighted in Part B
(yet it was important in Part a). These factors help to explain why the
value-weighted index in Part b produced a higher answer than the priceweighted index in Part a.

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Chapter 03 - Participating in the Market

Changing index values in a value-weighted index

13. Assume the following stocks make up a value-weighted index:
Corporation
Reese
Robinson
Snider
Hodges

Shares Outstanding
4,000
16,000
6,000
40,000

Market Price
$35
4
10
20

a. Compute the total market value and the weights assigned to each stock. Round to two
places to the right of the decimal point. (The weights may add up to slightly more
than 100 percent due to rounding.)
b. Assume the price of the shares of the Snider Corporation goes up by 50 percent, while
that of the Hodges Corporation goes down by a mere 10 percent. The other two stocks
remain constant. What will be the newly established value for the index?
c. Explain why the index followed the pattern it did in part b.
3-13. a)
Shares
Outstanding
4,000
16,000
6,000
40,000

Corporation
Reese
Robinson
Snider
Hodges

b)
Corporation
Reese
Robinson
Snider
Hodges

Shares
Outstanding
4,000
16,000
6,000
40,000

Market
Price
$35
4
10
20

Total Value
$140,000
64,000
60,000
800,000
$1,064,000
Market
Price
$35
4
15*
18**

Weight
13.16%
6.02
5.64
75.19
100.01%
or
approx. 100%
Total Value
$140,000
64,000
90,000
720,000
$1,014,000

*$10 150% = $15

**$20 90% = $18
Index

1, 014, 000
95.30
1, 064, 000

c)

Hodges Corporation has an initial weight of 75.19 percent in the

index, while Snider Corporation is only weighted as 5.64 percent.
Therefore, a 10 percent decline in Hodges Corporations stock
turns out to be more important than the 50 percent gain in Snider
Corporations stock.
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Chapter 03 - Participating in the Market

Changing index values in a value-weighted index

14. In problem 13, if the initial price of the shares of the Snider Corporation doubles
while that of the Hodges Corporation goes down by 7.5 percent, would the value of
the index change? The other two stocks remain constant. Do the necessary
computations.
3-14. Compute the new total value of the index.
Shares
Market
Corporation
Outstanding
Price
Reese
4,000
$35
Robinson
16,000
4
Snider
6,000
20*
Hodges
40,000
18.50**
*10 2

Total
Value
$ 140,000
64,000
120,000
740,000
$1,064,000

20

** 20 92.5% 18.50

Index

1, 064, 000
100 100
1, 064, 000

The value of the index would remain unchanged. Once again the heavy weighting
of the Hodges Corporation in comparison to the Snider Corporation tends to
overcome price change differentials.
Critical Thought CaseFocus on Ethics
Elaine and Izzy Polanski have been happily married for the last 10 years. Elaine is a
systems engineer for a major West Coast aerospace company, and Izzy is a pilot for a
commuter airline flying out of Los Angeles International airport. Together they anticipate
a taxable income of $116,000.
Both Elaine and Izzy are concerned about their potential large tax obligation of
$25,500. As the end of the year approached, they began to think of ways to reduce their
anticipated taxable income. Izzy suggested they evaluate their stock portfolio to see if
they might sell off a stock or two to create a deduction against their taxable income. They
have six stocks in their portfolio, and only one was trading at a loss from its original
purchase price. They hold 500 shares of Atlantic Cellular Company, and the stock has
fallen from $58 to $38 a share due to poor third-quarter earnings.

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Chapter 03 - Participating in the Market

Before they make a decision to sell, Izzy and Elaine complete an intensive
investigation of the company and find that the company is still fundamentally sound. It is
their view that investors overreacted to the poor third-quarter earnings announcement and
that prospects for the fourth quarter look considerably better. Furthermore, they think that
Atlantic Cellular Company has an excellent chance of winning a major contract with the
U.S. Treasury Department on the installation and use of sophisticated telephone
communication equipment. The other bidder on the contract is Atlas Corp., a firm in
which Izzy and Elaine currently hold 1,000 shares. Since they purchased the stock of
Atlas Corp. it has gone from $10 to $25.
To get a better feel for how the competition on the contract might turn out, Izzy
tells Elaine he might give Gordon Lewis a call. Lewis is currently the vice president of
Corporate Development at Atlantic Cellular Company and was Izzys roommate in
college. Elaine isnt sure this is such a good idea. Izzy counters with the argument that it
is always best to be as fully informed as possible before making a decision and that
Elaine, as a systems engineer, should know this better than anyone.
1. Do you think Izzy Polanski should call Gordon Lewis, his old college
roommate, to get information on the contract bid?
Izzy shouldnt call Gordon Lewis to ask about the telecommunications deal because
Gordon is bound by law not to reveal any inside information. If Izzy does call Gordon
and Gordon follows the law he wont be able to tell Izzy anything that is not already
public information. Izzy should call his account executive or do his own research by
looking at Atlas and Atlantic Cellular annual reports, proxy statements and new releases.
Elaine is correct it is not a good idea to call Gordon.
2. Regardless of your answer to question 1, do you think the Polanskis should
sell their stock in Atlantic Cellular Company? If they do sell the stock what
is the maximum deduction they can take from their taxable income this year?
The Polanskis are sitting on a loss of $20 per share ($58-38) on 500 shares of Atlantic
Cellular or a total loss of $10,000. If they sell their shares their maximum deduction is
$3,000 for the year. The $7,000 that is not deductable this year can be carried forward
until next year or used to offset against capital gains. They have several tax strategies
they can take. Since they dont know whether Atlas or Atlantic Cellular will win the deal
and they hold both shares, they may choose to sell a partial position in Atlantic Cellular.
They could sell 150 shares and take their $3,000 loss for this year and hold the other 350
shares with the hopes that Atlantic Cellular will win the contract. Because nobody knows
which company will win the contract, the Polanskis are hedged to some degree because
they own both companies. Most likely the company that doesnt win the contract will see
their stock price decline and the one that wins will see their stock price increase. So this
becomes a typical problem for an investor, do you shoot for the home run by trying to
guess which company will win or do you take a portfolio view and hold a portion of both
shares. If they sell all of Atlantic Cellular they are betting on Atlas winning the bid.
However, they can always wait 31 days and repurchase the shares. If they repurchase the
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Chapter 03 - Participating in the Market

shares before 31 days, then they cant take the loss on their income tax. This is called the
wash sale rule.
3. What strategy do you recommend for their holding in Atlas Corporation?
With 1000 shares worth $25,000 and a $15 per share gain the Polanskis are sitting on a
$15,000 capital gain. If we assume that this is a long-term capital gain, it would be taxed
at 15% in 2011 and 2012 or $2,250 in tax. Since Izzy and Elaine only hold six stocks in
their portfolio and two of them are in the telecommunications industry, we would
recommend that they sell some shares in Atlas Corp. and Atlantic Cellular and diversify
their portfolio. If Izzy really wants a tax deduction of $3,000 then he could sell some
Atlantic Cellular and offset some of the loss with a sale of Atlas. The number of shares of
each company sold would depend upon the tax strategy Izzy wants to follow and which
company he thinks will be the final winner of the bidding competition. It could be that
the market anticipates that Atlas will win and that is why the stock has a capital gain. If
they actually win the bid the news may already be impounded in the stock price.

3-12