
Concept explainers
a.
To compute: The rate of
Introduction:
Rate of return: When the annual income earned through an investment is expressed as a proportion in the form of percentage of the original investment, it is called as rate of return.
a.

Answer to Problem 6PS
The table comparing the
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Rate of return in percentages | -20% | 0 | 10% | 20% |
Explanation of Solution
Stock price S0=$100
Call option with exercise price X=$100
Call option’s selling price C=$10
Call option’s expiration=1 year
Available amount for investment=$10000
Let us follow the following steps to calculation the rate of return.
Step 1: Calculation of investment amount:
So, therefore in each case of price variation at an expiry period of 1 year i.e., at, $80, $100, $110, $120 the investment amount will $10000.
Step 2: Calculation of
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Profit/ Loss per share when the current price is $100. (Stock price after 1 year − Current price) | ![]() | ![]() | ![]() | ![]() |
Profit/Loss per total shares | ![]() | 0 | ![]() | ![]() |
Step 3: Calculation of rate of return in different prices at maturity
Calculation of rate of return:
The same formula is used in calculations shown in the table.
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Rate of return | ![]() | 0 | ![]() | ![]() |
Rate of return in percentages (Rate of return *100) | ![]() | 0 | ![]() | ![]() |
The maximum profit earned is 20 % and maximum loss to be borne is -20% when all of the investment amount is invested in stocks by the investor.
b.
To compute: The rate of return when the investment amount is invested in the stock options.
Introduction:
Rate of return: When the annual income earned through an investment is expressed as a proportion in the form of percentage of the original investment, it is called as rate of return.
b.

Answer to Problem 6PS
The table comparing the rate of return in percentages at different stock prices at maturity is as follows:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Rate of return in percentages | -300% | -100% | 0 | 100% |
Explanation of Solution
Stock price S0=$100
Call option with exercise price X=$100
Call option’s selling price C=$10
Call option’s expiration=1 year
Available amount for investment=$10000\
Let us follow the following steps to calculate the rate of return in this alternative.
Step 1: Calculation of investment amount:
So, therefore in each case of price variation at an expiry period of 1 year i.e., at, $80, $100, $110, $120 the investment amount will $10000.
Step 2: Calculation of profit/loss in different maturity prices
Note1: Calculation of profit/loss for long call= Stock price at maturity − Strike Price- Option premium paid by the investor
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Payoff per share when the strike price is $100. (Payoff=Stock price after 1 year − Strike price) | ![]() | ![]() | ![]() | ![]() |
Option premium per share paid by the investor | 10 | 10 | 10 | 10 |
Profit/Loss per share (Note 1) | ![]() | ![]() | ![]() | ![]() |
Profit/Loss for 10 contracts | ![]() | ![]() | 0 | ![]() |
Calculation of value of total contracts:
The same is used in all price variation cases in the above table.
Step 3: Calculation of rate of return:
The same formula is used in calculations shown in the table.
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Rate of return | ![]() | ![]() | 0 | ![]() |
Rate of return in percentages (Rate of return *100) | ![]() | ![]() | 0 | ![]() |
In this alternative, a maximum return of 100% and maximum loss to be borne is 300%. The reason is simple. It is a type of insurance contract where investor pays a premium and exercise the option only when required.
c.
To compute: The rate of return when $1000 is invested in options and $9000 is invested in
Introduction:
Money market fund: There are many types of securities in which the investment can be made. When the investor has the intention of investing in short term debt securities he/she can always opt for the money market fund. The money market fund is supposed to be an open-minded type of mutual fund. These are managed to maintain the net asset value’s stability at the highest point and at the same time pay the sufficient dividend to the investors in the form of dividends.
c.

Answer to Problem 6PS
The combined weighted average rate of return at different stock prices at maturity is as follows:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Weighted average rate of return from options contract | -30 | -10 | 0 | 10 |
Weighted average rate of return from money market fund | 3.60 | 3.6 | 3.6 | 3.6 |
Total | -26.40 | -6.40 | 3.60 | 13.60 |
Explanation of Solution
Stock price S0=$100
Call option with exercise price X=$100
Call option’s selling price C=$10
Call option’s expiration=1 year
Available amount for investment=$10000
Let us follow the following steps to calculate the rate of return in this alternative
Step 1: Calculation of investment amount when $1000 is invested in options contract
The same amount is applicable in all prices at maturity.
Step2: Calculation of Profit/Loss at different prices at maturity:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Payoff per share when the strike price is $100. (Payoff=Stock price after 1 year − Strike price) | ![]() | ![]() | ![]() | ![]() |
Option premium per share paid by the investor | 10 | 10 | 10 | 10 |
Profit/Loss per share (Note 1) | ![]() | ![]() | ![]() | ![]() |
Profit/Loss for 1 contracts | ![]() | ![]() | 0 | ![]() |
Calculation of value of total contracts:
The same is used in all price variation cases in the above table.
Step 3: Calculation of rate of return:
The same formula is used in calculations shown in the table.
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Rate of return | ![]() | ![]() | 0 | ![]() |
Rate of return (profit/loss amount) in percentages (Rate of return *100) | ![]() | ![]() | 0 | ![]() |
Step 4: Calculation of Weighted average rate of return- Note 2
Calculation of weighted average rate of return for option contract:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Weight of option contract investment ![]() | 0.10 | 0.10 | 0.10 | 0.10 |
Weighted average rate of return ![]() | ![]() | ![]() | 0 | ![]() |
Calculation of Profit/Loss of investment in money market fund at different price at maturity:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Return from money market fund ![]() | 360 | 360 | 360 | 360 |
Rate of return ![]() | 0.04 | 0.04 | 0.04 | 0.04 |
Rate of return in percentages (Rate of return *100) | 4 | 4 | 4 | 4 |
Weight of option contract investment ![]() | 0.90 | 0.90 | 0.90 | 0.90 |
Weighted average rate of return ![]() | 3.60 | 3.6 | 3.6 | 3.6 |
Step5: Calculation of combined weighted average rate of return:
Particulars | Amount (in $) when stock price is $80 | Amount (in $ ) when stock price is $100 | Amount (in $) when stock price is $110 | Amount (in $) when stock price is $120 |
Weighted average rate of return from options contract | -30 | -10 | 0 | 10 |
Weighted average rate of return from money market fund | 3.60 | 3.6 | 3.6 | 3.6 |
Total | -26.40 | -6.40 | 3.60 | 13.60 |
Want to see more full solutions like this?
Chapter 20 Solutions
Investments, 11th Edition (exclude Access Card)
- Moose Enterprises finds it is necessary to determine its marginal cost of capital. Moose’s current capital structure calls for 50 percent debt, 30 percent preferred stock, and 20 percent common equity. Initially, common equity will be in the form of retained earnings (Ke) and then new common stock (Kn). The costs of the various sources of financing are as follows: debt, 9.6 percent; preferred stock, 9 percent; retained earnings, 10 percent; and new common stock, 11.2 percent. a. What is the initial weighted average cost of capital? (Include debt, preferred stock, and common equity in the form of retained earnings, Ke.) b. If the firm has $18 million in retained earnings, at what size capital structure will the firm run out of retained earnings? c. What will the marginal cost of capital be immediately after that point? (Equity will remain at 20 percent of the capital structure, but will all be in the form of new common stock, Kn.) d. The 9.6 percent cost of debt referred to earlier…arrow_forward7. Berkeley Farms wants to determine the minimum cost of capital point for the firm. Assume it is considering the following financial plans: Cost (aftertax) Weights Plan A Debt .................................. 4.0% 30% Preferred stock .................. 8.0 15 Common equity ................. 12.0 55 Plan B Debt .................................. 4.5% 40% Preferred stock .................. 8.5 15 Common equity ................. 13.0 45 Plan C Debt .................................. 5.0% 45% Preferred stock .................. 18.7 15 Common equity ................. 12.8 40 Plan D Debt .................................. 12.0% 50% Preferred stock .................. 19.2 15 Common equity ................. 14.5 35 a. Which of the four plans has the lowest weighted average cost of capital? Use the Kd (cost of debt) = Y(1 - T), Kp (Cost of preferred stock) = Dp/Pp - F, Ke = D1/P0 + g formulas or I will not understand.arrow_forwardNeed use the Kd (cost of debt) = Y(1 - T), Kp (Cost of preferred stock) = Dp/Pp - F, Ke = D1/P0 + g formulas or I will not understand. Delta Corporation has the following capital structure: Cost Weighted (after-tax) Weights Cost Debt 8.1% 35% 2.84% Preferred stock (Kp) 9.6 5 .48 Common equity (Ke) (retained earnings) 10.1 60 6.06 Weighted average cost of capital (Ka) 9.38% a. If the firm has $18…arrow_forward
- Delta Corporation has the following capital structure: Cost Weighted (after-tax) Weights Cost Debt 8.1% 35% 2.84% Preferred stock (Kp) 9.6 5 .48 Common equity (Ke) (retained earnings) 10.1 60 6.06 Weighted average cost of capital (Ka) 9.38% a. If the firm has $18 million in retained earnings, at what size capital structure will the firm run out of retained earnings? b. The 8.1 percent cost of…arrow_forwardDillon Enterprises has the following capDillon Enterprises has the following capital structure. Debt ........................ 40% Common equity ....... 60 The after-tax cost of debt is 6 percent, and the cost of common equity (in the form of retained earnings) is 13 percent. What is the firm’s weighted average cost of capital? a. An outside consultant has suggested that because debt is cheaper than equity, the firm should switch to a capital structure that is 50 percent debt and 50 percent equity. Under this new and more debt-oriented arrangement, the after-tax cost of debt is 7 percent, and the cost of common equity (in the form of retained earnings) is 15 percent. Recalculate the firm’s weighted average cost of capital. b. Which plan is optimal in terms of minimizing the weighted average cost of capital?arrow_forwardCompute Ke and Kn under the following circumstances: a. D1= $5, P0=$70, g=8%, F=$7 b. D1=$0.22, P0=$28, g=7%, F=2.50 c. E1 (earnings at the end of period one) = $7, payout ratio equals 40 percent, P0= $30, g=6%, F=$2,20. Note: D1 is the earnings times the payout rate. d. D0 (dividend at the beginning of the first period) = $6, growth rate for dividends and earnings (g)=7%, P0=$60, F=$3. You will need to calculate D1 (the dividend after the first period).arrow_forward
- Terrier Company is in a 45 percent tax bracket and has a bond outstanding that yields 11 percent to maturity. a. What is Terrier's after-tax cost of debt? b. Assume that the yield on the bond goes down by 1 percentage point, and due to tax reform, the corporate tax falls to 30 percent. What is Terrier's new aftertax cost of debt? c. Has the after-tax cost of debt gone up or down from part a to part b? Explain why.arrow_forwardThe Squeaks Cat Rescue, which is tax-exempt, issued debt last year at 9 percent to help finance a new animal shelter in Rocklin. a. If the rescue borrowed money this year, what would the after-tax cost of debt be, based on its cost last year and the 25 percent increase? b. If the receipts of the rescue were found to be taxable by the IRS (at a rate of 25 percent because of involvement in political activities), what would the after-tax cost of debt be?arrow_forwardNo chatgptPlease don't answer i will give unhelpful all expert giving wrong answer he is giving answer with using incorrect values.arrow_forward
- Please don't answer i will give unhelpful all expert giving wrong answer he is giving answer with incorrect data.arrow_forward4. On August 20, Mr. and Mrs. Cleaver decided to buy a property from Mr. and Mrs. Ward for $105,000. On August 30, Mr. and Mrs. Cleaver obtained a loan commitment from OKAY National Bank for an $84,000 conventional loan at 5 percent for 30 years. The lender informs Mr. and Mrs. Cleaver that a $2,100 loan origination fee will be required to obtain the loan. The loan closing is to take place September 22. In addition, escrow accounts will be required for all prorated property taxes and hazard insurance; however, no mortgage insurance is necessary. The buyer will also pay a full year's premium for hazard insurance to Rock of Gibraltar Insurance Company. A breakdown of expected settlement costs, provided by OKAY National Bank when Mr. and Mrs. Cleaver inspect the uniform settlement statement as required under RESPA on September 21, is as follows: I. Transactions between buyer-borrower and third parties: a. Recording fees--mortgage b. Real estate transfer tax c. Recording fees/document…arrow_forwardHello tutor give correct answerarrow_forward
- Essentials Of InvestmentsFinanceISBN:9781260013924Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.Publisher:Mcgraw-hill Education,
- Foundations Of FinanceFinanceISBN:9780134897264Author:KEOWN, Arthur J., Martin, John D., PETTY, J. WilliamPublisher:Pearson,Fundamentals of Financial Management (MindTap Cou...FinanceISBN:9781337395250Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage LearningCorporate Finance (The Mcgraw-hill/Irwin Series i...FinanceISBN:9780077861759Author:Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan ProfessorPublisher:McGraw-Hill Education





