Tutorial 7 (Week 9)

Ch08
PROFESSIONAL APPLICATION QUESTIONS:

8.1 What is the difference between positive and negative gearing?

Positive gearing is where the annual income generated from an investment is greater than the interest and other tax
deductible expenses. Negative gearing is where the annual income generated from an investment is less than the
interest and other tax deductible expenses.

8.2 What are the risks associated with gearing?

• The anticipated annual income is less than expected
• The anticipated annual expenses are higher than expected.
• If the loan must be rolled over, the lender may change the rules or conditions of the loan which will affect the
benefits of the gearing exercise.
• The investor might lose their job and struggle to generate the cash flow necessary to service the outgoings,
particularly loan repayments.
• Circumstances may force the investor to sell the asset in less than favourable conditions.
• Asset specific factors can adversely affect the investment asset.
• The asset does not generate the capital gain anticipated.

8.3 An investor wishes to buy some shares by using a combination of their own money and borrowed funds.
They are unsure whether they should take out a margin loan which is secured against the shares or take out
a mortgage against the family home. What are the advantages/disadvantages of each approach?
Margin Loan Mortgage

Advantages No recourse to non-investment assets. Lower interest rate than margin loan.

Existing investment assets can be used Margin calls not required – security
as additional security if required. offered for loan is less price volatile.

Disadvantages Higher interest rate than mortgage. Family home could be at risk.

Need capacity to meet margin calls

when made – security offered for loan
is price volatile.

8.4 Outline three ways that an investor can satisfy a margin call.
• Contributing cash to reduce the outstanding loan balance.
• Pledging additional assets as security.
• Selling investment assets and using the proceeds of the sale to reduce the outstanding loan balance.
PROFESSIONAL APPLICATION EXERCISES:

8.11 Your client, Jason, wants to start a share portfolio using the $50 000 in equity that he has already saved
and possibly combine this with some borrowed funds. Assume the following:
 interest rates at 8%
 grossed-up dividend income of 6%
 annual capital gain of 4%
 MTR 37%.
What will be Jason’s net return in both dollar and percentage terms for the following levels of gearing if
he sells the investment asset a year and 1 day after he buys it?
a. 100% equity ($50 000 in equity)
b. 50% equity ($50 000 in equity and $50 000 in debt)
c. 10% equity ($50 000 in equity and $450 000 in debt)
100% Equity 50% Equity 10% Equity
Capital $ 50,000 $ 50,000 $ 50,000
Debt $ - $ 50,000 $ 450,000
Investment $ 50,000 $ 100,000 $ 500,000

Income $ 3,000 $ 6,000 $ 30,000

Less interest $ - $ 4,000 $ 36,000
Net income $ 3,000 $ 2,000 -$ 6,000
Tax payable $ 1,110 $ 740 -$ 2,220
Income after tax $ 1,890 $ 1,260 -$ 3,780

Capital gain $ 2,000 $ 4,000 $ 20,000

Assessable gain $ 1,000 $ 2,000 $ 10,000
CGT $ 370 $ 740 $ 3,700
Capital gain less CGT $ 1,630 $ 3,260 $ 16,300

Total return after tax $ $ 3,520 $ 4,520 $ 12,520

Total return after tax % 7.0% 9.0% 25.0%

8.13 Your client, Malala, has the following portfolio which he has financed through a $200 000 margin loan.
What is her safety margin?

Safety margin = 1 – (200,000/228,000)

= 12%
8.14 Assume that the stock market has suffered considerable falls. Malala’s portfolio from exercise 8.13 is
now:

Her lender has made a margin call. Malala does not have any cash to meet the margin call nor does she
have any additional assets to pledge as security. For each of the shares in her portfolio, calculate how
much she would need to sell to satisfy the margin call.
Cash required = 200,000 – 190,750 = 9,250
Company Market value LVR Security Need to sell
9,250/1-0.75)
AGK $ 70,000 75% $ 52,500 $ 37,000 or
BOQ $ 65,000 70% $ 45,500 $ 30,833 or 9,250/1-0.70)
DOW $ 85,000 65% $ 55,250 $ 26,429 or 9,250/1-0.65)
CSL $ 50,000 75% $ 37,500 $ 37,000 9,250/1-0.75)
$ 270,000 $ 190,750

Safety margin -5% 1 – (200,000/190,750)

Loan $ 200,000
Security $ 190,750
Cash required $ 9,250

8.17 Wal is a sheep farmer from out west. When he shears his flock in 3 months’ time he will have
approximately 9,000 kilograms of wool. The current price of the SFE Greasy Wool Futures 21 micron
contract is $11.20 per kilogram for delivery in three months. Wal decides to sell four SFE Greasy Wool
Futures 21 micron contracts at $11.20 per kilogram.
What is Wal’s gain/loss on the futures contract in dollar terms if in three months’ time the price of wool
is:

(Note: 1 SFE Greasy Wool Futures 21 Micron contract = 2,500kg; see pg. 333 of the text book)
 $13.75
Loss = 11.20 – 13.75 = (2.55)
(2.55) * 10,000 = $(25,500)

 $10.12
Gain = 11.20 – 10.12 = 1.08
3.63 * 10,000 = $10,800

 $11.20
Break even = 11.20 – 11.20 = $0
8.18 From exercise 8.17 what is Wal’s overall gain/loss when his physical position is netted against his futures
position for each of the prices listed above?

13.75 – 11.20 = 2.55

2.55 * 9,000 = 22,950