Question 1

Martin uses $40,000 of his own funds and borrows additional funds through a margin lending facility to buy a total of $100,000 worth of shares.

The value of Martin's total share portfolio subsequently decreases in value to $80,000.

a.How much did Martin borrow?

$100,000 -$40,000 = $60,000

b.What is the original Loan to Valuation Ratio?

60%

c.If the value of the total share portfolio drops to $80,000 what would the new Loan to Valuation Ratio be?

80%

d.After the drop in the value of the share portfolio, what is the proportion of equity that Martin has in the investment?

$40,000 x 35% = $14,000

Question 2

James uses $30,000 of his own funds and borrows additional funds to buy a total of $60,000 worth of shares.Under the terms of James's margin lending arrangement, a margin call will be triggered when the Loan to Valuation Ratio exceeds 70%.

a.What is the current Loan to Valuation Ratio?

$30,00 - $90,000 = 33.33%

b.If you are told the Loan to Valuation Ratio is now 70%, has the share investment value increased or decreased?

Decreased

c.If you are told the Loan to Valuation Ratio is now 70% what is the equity proportion of the investment?

The margin lending contract specifies that a margin call will be made if the Loan to Valuation Ratio exceeds 70%.

d.For that margin call to be triggered, the value of the investment will have to fall.What will the value of the total investment have to fall to for a margin call to be made?

Question 3

Explain why exceeding the maximum Loan to Valuation Ratio does not necessarily trigger a margin call.

Question 4

List 4 things a client should consider in order to reduce the chance of a margin call.

Question 5

When gathering client data to assess whether a gearing strategy is appropriate, what client data would you need to obtain to make that decision?

Assessment Activity 2

Simulation exercise

Margin Lending

Activity instructions to candidates

This is an open book assessment activity.

You are required to read this assessment and answer all 7 questions that follow.

Please type your answers in the spaces provided.

Please ensure you have read "Important assessment information" at the front of this assessment

Estimated time for completion of this assessment activity: 1 hour

Background

Juliette and Jason are in their mid 40's, and married with 4 teenage children.They have $50,000 in surplus funds which they would like to invest into company ABC as they believe this to be a solid company with healthy dividends. Although purchasing shares in only one company does not offer diversification, and will increase the risk of the investment, Juliette and Jason are diversified in their superannuation funds and this keeps it simple for illustrative purposes. The problem is that Juliette has a much greater tolerance for risk than her husband.She is prepared to borrow 70% of the value of the total investment. Jason on the other hand is only prepared to borrow 50% of the value of the total investment.

ABC shares are currently trading at $5 per share.

As their adviser, you have already explained to them how margin lending works.

They want to know how heavily exposed they will be in the event that the market falls by 20%.

Complete the following questions to show Juliette and Jason the impact on a margin loan if they adopt Juliette's more aggressive strategy compared to Jason's more conservative strategy.

Assumptions

Current loan interest rate is 6.4%

Maximum lender loan to value ratio is 70%

Buffer is 6%

Required:

Using Juliette's strategy of investing $50,000 of their own funds, and taking out a margin loan with a loan to value ratio of 70%:

1.What will be the total amount of the margin loan?

2.Using Juliette's strategy, how many ABC shares can they purchase using this strategy (ignoring brokerage)?

3.If, the very next day, the price of ABC shares drops 20% to $4 per share, what is the new LVR using Juliette's strategy?

Using Jason's strategy of investing $50,000 of their own funds, and taking out a margin loan with a loan to value ratio of 50%:

4.What will be the total amount of the margin loan?

5.Using Jason's strategy, how many ABC shares can they purchase using this strategy (ignoring brokerage)?

6.If, the very next day, the price of ABC shares drops 20% to $4 per share, what is the new LVR using Jason's strategy?

7.Explain to Juliette and Jason, the consequences of the different outcomes depending on whether they use Juliette's strategy or Jason's strategy.

Assessment Activity 3

Scenarios

Gearing/Margin Lending

Activity instructions to candidates

This is an open book assessment activity.

You are required to read this assessment and answer all 3 questions that follow.

Please type your answers in the spaces provided.

Please ensure you have read "Important assessment information" at the front of this assessment

Estimated time for completion of this assessment activity: 2-3 hours

Question 1

Max and Raelene were hoping to retire in 5 years' time but recently, they realised that in order to have sufficient income in their retirement years, they would need to work for an extra 7 years.

They are considering gearing as a means to accelerate their wealth creation possibilities over the next 7 years whilst they continue to work and have surplus cash flow.

Required

a.Explain how margin lending would work for Max and Raelene if they want to use their existing $80,000 jointly held shares as security for a $50,000 jointly-held margin loan.

b.If Max and Raelene were comfortable with a loan to value ratio (LVR) of 45%, how much would they be able to borrow based on their share portfolio currently being worth $80,000?

c.If the maximum Loan to Valuation Ratio offered by the margin lender was 75% prior to a margin call being issued, what two options would Max and Raelene have if the portfolio fell in value considerably and they received a margin call? Explain how such options would play out in reality.

Question 2

An older client of yours, Grace has brought you a diagram she saw in the finance section of a newspaper.She knows a little about margin lending and asks you to explain what this diagram means.

Required

a.Use the example depicted in the diagram below to explain to Grace how buying shares with a margin loan works.

Margin Loan:

$70,000

Investor's Funds:

$30,000

Total investment value

$120,000

Total investment value

$80,000

b.Explain the risks associated with margin lending

Question 3

a.Two investors make an investment in the Australian equity market index (ASX200). Both investors have $100,000 of their own funds to invest. Investor A obtains a margin loan in the amount of $55,000, while Investor B who is not comfortable with debt, will only invest his own money. Complete the table below to show the effect of the index increasing in value by 50% on the portfolios of both investors.

Geared Portfolio

Investor 1

Ungeared Portfolio

Investor 2

Initial investment

Borrowed funds

Portfolio value

Scenario 150% rise in the value of the portfolio

Portfolio value

Less Loans outstanding

Net portfolio value

% Return on initial investment

Loan to Value Ratio (LVR)

b.Suppose the index fell by 50%. Complete the table below to show the impact this will have on the positions of both investors.

Geared Portfolio

Investor 1

Ungeared Portfolio

Investor 2

Initial investment

Borrowed funds

Portfolio value

Scenario 250% fall in the value of the portfolio

Portfolio value

Less Loans outstanding

Net portfolio value

% Return on initial investment

Loan to Value Ratio (LVR)

Assessment Activity 4

Case Study

Debt Recycling

Activity instructions to candidates

This is an open book assessment activity.

You are required to read this assessment and answer all 4 questions that follow.

Please type your answers in the spaces provided.

Please ensure you have read "Important assessment information" at the front of this assessment

Estimated time for completion of this assessment activity: 2 hours

Case Study

You are a financial planner who is required to present a Statement of Advice to the following clients, Franca and Carlos Pound who are 58 years and 60 years respectively.

About their family

Franca and Carlos have 3 children; Bianca, Peter and Tania who are 31, 29 and 27 respectively. Tania, the youngest child still lives at home with Carlos and Franca and doesn't pay any board. She has recently completed post graduate studies in psychology and has been saving up for a deposit on her first house with her parent's blessing. Tania plans to purchase her first home in the near future, as long as she can find the right house. She will move out of the family home once this has been achieved. Carlos and Franca's other two children are both financially independent and have left the "family nest".Bianca, the oldest child is married to Mathew and is also 5 months pregnant with their first child (and Franca and Carlos's first grandchild). Bianca is a secondary school teacher and Mathew (her husband) is in IT support. Peter, the middle child works as a manager of a restaurant, and is single.

Their financial situation

Franca works part-time earning $53,000 before tax as a speech pathologist and Carlos works as a construction project manager earning $98,000 before tax. They estimate at the moment they are able to save approximately $2,900 per month since their eldest two children left home. They believe once Tania leaves home this cashflow saving amount will increase to $3,700 per month. They anticipate this will occur within the next 12 months.

Franca and Carlos own their own home in joint names. They believe their home is worth conservatively $625,000. They still have a mortgage of $67,000 with NAB. The loan is a principal and interest loan, with a variable interest rate of 5%.

They own some direct shares in joint names which they purchased via various initial public offerings and de-mutualisations (e.g. AMP) over the past 20 years. The shares they own are CBA, Qantas, AMP, and Telstra. Combined, the shares are worth $75,000 based on current market values. The gross unrealised capital gain across all shareholdings (if the shares were to be sold) is approximately $46,000. The break-up of their direct shares is below:

Today's Market ValuePurchase Value

CBA$30,500$4,500

Qantas$7,500$5,500

AMP$22,600$5,500

Telstra$14,400$13,500

Franca and Carlos want to retire when Carlos reaches age 65 - in 5 years' time. They currently have their superannuation monies in XYZ Superannuation and ABC Superannuation. Their balances are as follows:

Carlos - $421,500 (XYZ Superannuation Fund)

Franca - $348,400 (ABC Superannuation Funds)

Based on the risk profile they have completed in your pre-appointment pack you sent them prior to your first appointment, Carlos and Franca have indicated they are 'moderately conservative' investors with respect to their superannuation monies. The five different risk profiles are provided below for your convenience.

Indicative Investor Risk Profile

Growth assets in portfolio

Income assets in portfolio

Description

Conservative

0% - 25%

75% - 100%

You are a conservative investor who does not wish to take any investment risk. Your priorities are the safeguarding of your investment capital. You are prepared to sacrifice higher returns for peace of mind.

Moderately Conservative

10% - 30%

70% - 90%

You are a moderately conservative investor who is prepared to accept a small amount of risk. Your priority remains the preservation of capital over the medium to long term. You may have some understanding of investment markets; however you cannot afford to take any chances with your capital.

Balanced

25% - 50%

50% - 75%

You are a balanced investor with some understanding of investment market behaviour and can accept some short term risk to your capital. You do not wish to see all of your capital eroded by tax and inflation and are prepared to take a small short term risk in order to gain longer term capital growth.

Assertive

45% - 65%

35% - 55%

You are an assertive investor who understands the movement of investment markets. You are most interested in maximising long term capital growth, although you do not wish to make unbalanced investment decisions. You are happy to sacrifice short term safety in order to maximise long term capital growth.

Aggressive

75% - 100%

0% - 25%

You are an aggressive investor. You are prepared to sacrifice your investment capital in pursuit of the highest long term capital growth investment. You are most interested in reducing your taxable income and have an understanding of the behaviour of investment markets.

Required

Carlos and Franca are interested in growing their wealth possibilities as much as possible prior to retirement. Whilst 5 years of working might have been their target initially, you have subsequently provided them with a few home truths about how much capital they would require at retirement to meet their required income needs (estimated at $75,000 net of tax in today's dollars). This realisation from Carlos and Franca has led them to consider working for at least 7 more years, rather than their initial 5 year estimate. Carlos and Franca also are considering gearing as a means to accelerate their wealth creation possibilities over the next 7 years whilst they continue to work and have surplus cash flow. As a responsible financial adviser, you have explained all the risks of gearing to Carlos and Franca. You have made them re-examine their risk profile after your explanation of the risks, coupled with the reality they will be underfunded in retirement the way they are going at the moment. Carlos and Franca have indicated to you they are comfortable borrowing up to $75,000 to invest in Australian equities (shares) despite their risk profile demonstrating they are "moderately conservative investors". They are also attracted to the tax benefits of gearing.Obviously, you have explained to Carlos and Franca that they need to have a high (aggressive) risk profile in order to borrow money and invest that money into 100% growth assets. They agree there is a contradiction to some extent in being a moderate conservative investor when it comes to their super, but at the same time wanting you to facilitate a gearing strategy for them (as explained above) without touching their super. You explain to Carlos and Franca that you will need to document this strategy via a Statement of Advice.

a)Carlos and Franca would like to use their existing $75,000 jointly held shares as security for a jointly-held margin loan. Even though the lender will allow a 70% LVR, Carlos and Franca would like a more conservative LVR and would only like to gear at a level of 40%.Calculate the total amount of their investments which will include their own capital of $75,000 and a loan provided by a margin lender which is geared at 40%. Please show all your workings.

b)Explain to Carlos and Franca how adopting a conservative gearing ratio of 40% will provide protection in a downward market.

c)Explain to Carlos and Franca the difference between a home equity loan to borrow money in order to purchase $50,000 of growth based investments, compared to a margin lending strategy for this purpose. What benefits would a home equity loan have over a margin loan?

d)Explain how debt recycling could work in regard to Carlos and Franca's current situation.