Investing an Inheritance

The Keller brothers, Victor and Darin, could not be more different. Victor is assertive and enjoys taking risks, while Darin is reserved and is exceedingly risk averse. Both have jobs that pay well and providing fringe benefits, including medical insurance and pension plans. You are the executor for their grandfathers estate and know that each brother will soon inherit $85,000 from the estate. Neither has an immediate need for the cash, which could be invested to meet some long term financial goal.

Once the funds has been received, you expect Victor to acquire some exceedingly risky investment(if he does not immediately squander the money).You would be surprised, however, if Darin chose to do anything other than place the funds in a low-yielding saving account. Neither alternative makes financial sense to you, so before the distribution of the funds you decide to offer financial suggestions that would reduce Victors risk exposure and increase Darins potential return.

Given the brothers ages and financial condition, you believe that equity investments are appropriate. Such investments may satisfy victors propensity to take risks and increase Darins potential return without excessively increasing his risk exposure (willingness to assume risk). Currently, the stock of Choice Juicy Fruit is selling for $60 and pays an annual dividend of $1.50 a share. The companys line of low-to-no sugar juice offers considerable potential. The margin requirement set by the Federal Reserve is 60 percent, and the brokerage firms are charging 7 percent on funds used to purchase stock on margin. While commissions vary among brokers, you decide that $70 for 100-share purchase or sale is a reasonable amount to use for illustrative purposes. Currently, commercial banks are paying only 3 percent on savings accounts.

To give the presentation focus, you decide to answer the following questions:

• What is the percentage return earned by Darin if he acquires 100 shares, holds the stock for a year, and sells the stock for $80?
• What is the percentage return earned by Victor if he acquires 100 shares on margin, holds the stock for a year, and sells the stock for $80? What advantage does buying stock on margin offer Victor?
• What would be the percentage returns if the sale prices had been $50 or $100?
• Must the two brothers leave the stock registered in street name? If not, what would be the advantage of leaving the stock with the broker? Does leaving the stock increase their risk exposure?
• What would be the impact on the brothers return if the rate of interest charged by the broker increases to 10 percent?
• If the maintenance margin requirement were 30 percent and the price of the stock declined to $50, what impact would that have on each brothers position? At what price of the stock would they receive a margin call?
• Why would buying the stock be more advantage to both brothers than the alternative you anticipate them to select?