Susan would like to purchase XYZ stock, which currently has a price of $40. The stock is expected to pay a $2 dividend one year from today. Susan can either pay $40 using cash, or borrow $15 from her brokerage firm and pay the remaining $25 using her cash. The annual interest rate on the margin loan is 8%. Assume that the stock price in one year is $28, immediately after paying the dividend.

 

1. If Susan buys this stock with 100% cash, what was her % return over this one-year period?
2. If Susan buys this stock on margin (using the $15 loan), what was her % return over this one-year period?
3. What does this example illustrate about the risks associated with margin trading?   If the stock market is efficient, will any rational investor trade using margin loans?