Case: RAVI DUMAR'S HIGH-FLYING MARGIN ACCOUNT
Ravi Dumar is a stockbroker who lives with his wife, Sasha, and their five children in Adelaide. Ravi firmly believes that the only way to make money in the market is to follow an aggressive investment posture-for example, to use margin trading. In fact, Ravi himself has built a substantial amount of equity over the years. He currently holds $75 000 worth of shares and his margin loan account stands at only $30 000. Recently, Ravi uncovered a share that, on the basis of extensive analysis, he feels is about to take off. The share, Running Shoes Ltd (RS), currently trades at $2 per share. Ravi feels it should soar to at least $5 within a year. RS pays no dividends, the margin lender is prepared to accept a loan to value ratio of up to 50% for his portfolio, and margin loans are now carrying an annual interest charge of 10%. Because Ravi feels so strongly about RS, he wants to do some pyramiding by using his margin loan account to purchase 10 000 shares.
QUESTIONS
1. Discuss the concept of pyramiding as it applies to this investment situation
2. Ravi buys the 10 000 shares of RS through his margin account. (Bear in mind that this is a $20 000 transaction.)
a. What will the loan ratio of the margin account be after the RS transaction if Ravi uses $10 000 from the margin loan and $10 000 of his own money to buy the shares?
b. What if he uses only $2500 equity and obtains a margin loan for the balance ($17 500)?
c. How do you explain the fact that the shares can be purchased using 87.5% debt from the margin loan when the prevailing maximum loan ratio is 50%?
3. Assume that Ravi buys 10 000 shares of RS at $2 per share with a minimum cash investment of $2500 and that the share does take off and its price rises to $4 per share in a year.
a. What is the return on invested capital for this transaction?
b. What return would Ravi have earned if he had bought the shares without using a margin loan-that is, if he had used all of his own money?
4. What do you think of Ravi's idea to pyramid? What are the risks and rewards of this strategy?