CFA Mock afternoon - question 85

[hei.so]

I understand why dividend is subtracted from total return to get price apprecation but why is margin interest added?
…the price at which the investor sold the stock is closest to:
B is correct.
Total purchase value = Purchase price × Shares purchased / $22 × 700 = $15,400
Initial equity = Total purchase value ÷ Leverage ratio / $15,400 ÷ 1.6 = $9,625
Amount borrowed = Total purchase value – Initial equity / $15,400 – $9,625 = $5,775
Margin interest paid = Call money rate × Amount borrowed / 4% × $5,775 = $231
Dividend income = Dividend per share × Shares purchased / $0.60 × 700 = $420
Total return on the initial equity / 12% × $9,625 = $1,155
Gain from price appreciation = Total return – Dividend + Margin interest / $1,155 – $420 + $231 = $966
Price at which investor sold the stock = Gain from price appreciation per share + Purchase price / ($966 ÷ 700) + $22 = $23.38

 

[KawiGreen]

This one tripped me up too.

 

[S2000magician]

I haven’t seen the problem, but it appears that the total return is after everything: receiving the dividend and paying for the margin loan. Thus, to get the price appreciation, you have to remove the effect of receiving the dividend (by subtracting it) and paying the margin interest (by adding it).

 

[bartmane]

and remember there is no point in multiplying by Shares purchased. No matter if there are 700 shares or 1 share, the total return on investment will be the same.

 

[hei.so]

S2000magician wrote:
I haven’t seen the problem, but it appears that the total return is after everything: receiving the dividend and paying for the margin loan. Thus, to get the price appreciation, you have to remove the effect of receiving the dividend (by subtracting it) and paying the margin interest (by adding it).

I was debating about the total return. Is it normal to assume that the total return is after everything? I thought it was only price return (capital gain/loss) plus dividends?
It was tricky because one of the answers is with the margin loan cost and another without.

 

[inCLYNEd.Honoka]

I would figure total return is inclusive of all costs and dividends…

 

[robertucla]

This problem got me as well. I don’t think there are any examples in the book that calculate it this way but I could be wrong.

 

[LePetitCaporal]

Yes; the wording is not good. It got me too. I hope they will do a better job on the actual exam….

 

[S2000magician]

hei.so wrote:

S2000magician wrote:I haven’t seen the problem, but it appears that the total return is after everything: receiving the dividend and paying for the margin loan. Thus, to get the price appreciation, you have to remove the effect of receiving the dividend (by subtracting it) and paying the margin interest (by adding it).

I was debating about the total return. Is it normal to assume that the total return is after everything? I thought it was only price return (capital gain/loss) plus dividends?

Yes; that’s the “total” part.

hei.so wrote:It was tricky because one of the answers is with the margin loan cost and another without.

Expect that on the real exam. CFA Institute has been writing these exams a lot longer than anyone here has been studying for them (indeed, a lot longer than most of you have been alive!), so they know the most common mistakes you will make; the wrong answer choices reflect that knowledge.

 

[ann34]

Total Return is after everything. If there is Commission too, we have to deduct it to get the Total Return, thus the equation:
Total Return = Capital gains + Dividends - Margin Interest - Commissions
So Capital Gains or Price Appreciation = Total return - Dividends + Margin interest + Commissions
There are examples of this kind of problem in the CFAI reading, even in EOC Qs.