Question 2

You would like to create a holding corporation that holds 10M shares of a penny stock (ticker: ZON) for exactly one year. ZON is currently trading at $1.00 per share; thus, 10M shares would cost $10M to purchase. Suppose that you have $8M in personal cash. You borrow another $2M in cash so that you can purchase $10M worth of ZON. The $2M loan is interest-free and must be paid back next year. Thus, your investment consists of $8M in personal cash (equity) and $2M in borrowed cash (debt).

a) One year passes. Suppose that the price of ZON increases to $1.60 per share. What is the percentage return on your $8M personal investment, after you sell off your 10M shares and pay back your $2M loan? (Hint: the percentage return on your personal investment is calculated as (leftover cash after selling the shares and repaying the loan minus value of personal investment) divided by value of personal investment.)

b) Suppose instead that the price of ZON decreases to $0.50 per share. What is the percentage return on your $8M personal investment, after you sell off your 10M shares and pay back your $2M loan?

c) When you create your holding corporation, you assume that there is a 50% chance that the price of ZON will increase to $1.60 per share next year, and a 50% chance that the price of ZON will decrease to $0.50 per share next year. What is the expected return on your personal investment? (Hint: use these probabilities and the returns you calculated in parts (a) and (b) to find the expected return.)

Go back to the beginning of the question and instead assume that you only have $5M in personal cash. Thus, you borrow another $5M in additional cash to make the $10M purchase of ZON stock.

d) Answer parts (a) to (c) again under the assumption that you purchase the $10M of ZON stock using $5M in personal cash and $5M in borrowed cash.

e) What do the expected returns calculated in parts (c) and (d) tell you about the relationship between debt and expected return on equity (i.e. the expected return on your personal investment)?