BU111 Exam-AID

BU111 Exam-AID

Note: This material is great for review

Agenda

• Tax– Total Taxable Income vs Taxation of Investment Returns– Effective Tax Rates

• Stocks– Going long

• Bonds– Yields and Pricing

• Short Selling– Short Call

• Margin Buying– Margin Call

• Options– PUT and CALL

• Combined Problem• Keys to Success

Total Tax Payable for a YearSteps to Success

• Begin by determining the individuals total taxable income for the year

Employment Income+ 50% x (Capital Gains – Capital Losses) (if applicable)

+ 100 % x Interest Received (if applicable)

Total Taxable Income

2. Use Tax Tables 1 – 3 to calculate total tax payable for the year

Federal Tax Payable (Table 1) + Ontario Tax Payable (Table 2) + Ontario Surtax Payable (Table 3)

Total Tax Payable

3. DO NOT USE MARGINAL TAX RATES IN ANY SHAPE OR FORM!!!!!

Total Tax Payable for a YearQuestion #1

Suppose an individual has employment income of $56,000, Capital Gains of. $5,000, Capital Losses of $1,000, and interest received of $10,000 during the 2010 year. What is the total tax payable for the 2010 year?

Employment Income+ 50% x (Capital Gains – Capital Losses)+ 100% x Interest Received Total Taxable Income

$56,000+ 0.5 x ($5,000 - $1,000)+ $10,000 $68,000

→1. Determine Total Taxable Income

2. Use Tax Tables 1 - 3

Federal Tax Payable (Table 1) + Ontario Tax Payable (Table 2) + Ontario Surtax Payable (Table 3) Total Tax Payable

→ [$6,146 + ($68,000 - $40,971)*0.22]+ [$1,874 + ($68,000 - $37,108)*0.0915]+ [($4,701 - $4,006) x 0.20] $16,932 (Total Tax Payable)

Answer:

Marginal Tax RatesSteps to Success

***Remember: Marginal Tax Rates are only used to estimate tax owed on investments!

1. Determine the amount of investment that is subject to tax.

2. Use Table #4 to determine which marginal tax bracket the individual falls in

- Could be stated (ie: “Investor falls in 26% Federal Tax Bracket) - If not stated, use the investors “Employment Income” or “Other Sources of Income

for the Year” to establish which bracket.

• Calculate the Marginal Tax Rate that applies:

Marginal Tax Rate % = Federal Rate % + Provincial Rate % +(Provincial % x Surtax %)

4. Calculate to tax payable on the investment:

Tax Payable on Investment = [Amount Subject to Tax] x Marginal Tax Rate %

Steps to Success

• Determine the Net Capital Gain

Net Capital Gain = Capital Gains – Capital Loss

• Only 50% of the value of a capital gain is subject to tax!

Capital Gain Subject to Tax = 0.5 x [Net Capital Gain]

**Note: IF [Net Capital Gain] = 0 or -, then no tax is owed.

• Determine Tax Owed on Capital Gain by multiplying by the investors marginal tax rate!

Tax Owed on Capital Gain = [Capital Gain Subject to Tax] x Marginal Tax %

Tax on Net Capital Gains

Example

• In 2010 you made two stock market investments. On the 1st investment, you earned a Capital Gain of $10,000. On the 2nd investment you realized a Capital Loss of $5,000.

If you have employment income of $60,000

during 2010, what is the tax you owe on JUST

your investments?

AnswerStep 1: Net Capital Gains

= Capital Gains – Capital Losses= $10,000 – $5,000= $5,000

Step 2: Capital Gains subject to tax

= Net Capital Gains x 50%= $5,000 x 50%= $2,500

Step 3: Capital Gains Tax Payable

= [Capital Gains subject to tax] x [Investor’s Marginal Tax Rate %] = $2,500 x [22% + 9.15% + (0)]= $2,500 x 31.15% (this is the Marginal Tax Rate derived using $60,000

income)= $778.75

Effective Tax Rate on Capital Gains

Recall, the formula for Effective Tax Rate:

Effective Tax Rate = Tax Payable/Investment Return

In other words “What % of what I made is paid to the government (taxes)”

From our Previous Example:

Effective Tax Rate = $778.75/$5,000* = 15.575%**

* Remember our return is the total dollar amount earned, not the amount subject to tax!

** The Effective Tax Rate on Capital Gains is 50% the marginal rate!! 31.15 x 50% = 15.575%

Steps to Success

• Determine the amount of interest received

Note: The coupon payments on a bond are received in the form of interest!

• Determine the amount of tax owed

Note: Interest is 100% taxable

Therefore, Tax owed on interest = [Interest Earned] x [Marginal Tax Rate %]

Tax on Interest Income

Example

• Assume that you are an Ontario investor that held some bonds in 2010 that paid a total of $900 interest in the form of coupon payments.

What is the total tax that you would owe on the interest if this investor is in the highest marginal tax bracket?

Answer

Amount of interest received = $ 900

Marginal Tax Rate = 46.41%(using Tax Tables #1-3 and Marginal Rate Formula)

Tax Payable = Interest x Marginal Rate = $900 x 0.4641

=$417.69

Effective Tax Rate on Interest




Effective Tax Rate = $417.69/$900 = 46.41% **

** The Effective Tax Rate on Interest is simply the investors marginal rate!

Steps to Success

• Calculate the total dividends received

1. Calculate the amount of dividends subject to tax (gross up 44%; both Fed and Prov)

Amount of Dividends Subject to Tax = 144% x Dividend Amount

• Calculate Federal Tax, Provincial Tax, and Surtax separately

-Note: Federal Tax Credit of 18%-Note: Ontario Tax Credit of 6.4%

Tax on Dividends

Elton John made $75,000 playing the piano in 2010. Also, during the year, he earned dividends on his investments totalling $1,500. How much tax does Elton owe on the dividends?

Example

Answer

NOTE: ALL TAX RATES DERVIVED FROM $75,000 IN EMPLOYMENT INCOME Federal Tax Payable:Dividend amount = $1500Amount subject to tax = $ 2160 (1500 x 1.44)Fed Tax Payable (22%) = $ 475.20 (0.22 x 2160)Fed Tax Credit (18%) = $ 388.80 (0.18 x 2160)Total Fed Payable = $ 86.40

Ontario Tax Payable:Ont Tax (11.16%) = $241.06 (0.1116 x 2160)Ont Tax Credit (6.4%) = $138.24 (0.064 x 2160)Total Ont Payable = $102.82

Ontario Surtax (56%) = $57.58 (0.56 x 102.82)Total Tax Payable = $246.80

Effective Tax Rate on Dividends




Effective Tax Rate = $246.80/$1,500 = 16.45%

After-tax Yield1. Determine how much cash the investor earned from the investment

• Determine how much cash that investor owes in taxes on that investment**Remember, if there is interest paid (from a margin account), it can be

used to reduce the total amount of tax payable because it is tax deductable!

3. Determine (From Step 1. and Step 2.) what the amount of cash the investor got to keep after all tax and expenses were paid

“How much did the investor REALLY make on this investment?” aka the Amount of $ in their pocket at the end

4. Take the amount determined in Step 3 and divide by the total amount invested

Suppose you are an investor that recently made an investment using margin. The investor earned a capital gain of $2,000 and paid interest of $100.

The investment required the investor put up $10,000. The investment was held for 3 months.

If the investor is in the highest marginal tax bracket, what is the annualized after tax yield on this investment?

After-tax Yield - Example

After-tax Yield – Example

1. Calculate Cash Earned From the Investment

= $2,000 (Capital Gain) - $100 (Interest)= $1,900

• Calculate Cash owed in the form of taxes:

= [ (50% x $2,000) - $100 ] x 46.41%= $417.69

2. Calculate Annualized After-Tax Yield

= [($1,900 - $417.69) / ($10,000)] x (12/3)=14.82% x 4= 59.28%

Stocks – Straight Buy/Sell• Buying Stocks:

– Determine the number of shares you are going to purchase.

-Cost of Acquiring (“Buy”) = # Shares x Price per Share

– Don’t forget commissions!» - Commission in = 2% x [Cost of Acquiring]

• Selling Stocks:

– Take the number of shares you purchased, and multiply by the price at which you have decided to sell:

-Proceeds from Selling = # shares held x Price per Share

– Multiply the proceeds from selling the stocks by the commission rate (2%) to determine Commission Out [Cost of Selling]

Bid Vs. Ask Prices

• Bid Price: Represents highest amount that an investor is currently willing to pay to acquire a board lot of shares of a particular bond

• Ask Price: Represents the lowest amount that an investor is willing to accept (sell) for a board lot of shares or a particular bond

• A buyer submitting a market order to buy would pay the current ASK price, and a seller submitting a market order to sell would receive the current BID price

Example

• You own 500 shares of XYZ Company Stock that was currently quoted at an 8.50 Bid and an 8.55 Ask.

• How much would you receive if you decided to sell your holding?You would receive a BID price of $8.50, therefore:500 shares X $8.50 = $4250

Less commission $85.00 (2%) =$4,165• How much would is cost you to purchase an

additional 250 shares?You would pay the ASK price of $8.55, therefore:250 shares X $8.55 = $2137.50 Plus commission $42.75 (2%)= $2180.25

Bonds

Steps for Success!• Finding the appropriate price for a

bond:– Make rough bond yield of current bond

equal to coupon rate of bonds trading at par (current, new)

Example

• ABC Company issues bonds with a 8.60% coupon at a price of 97.50. They mature on October 31, 2021. Calculate the rough yield. Assume the bond is purchased Oct 31, 2009 and will be held to maturity.

• Rough Bond Yield:

(Coupon Rate X Par Value) + (Par Value – Purchase Price) # of years to maturity

Purchase price of bond

= (1000 x 0.086) + (1000 – 975) 12

975=88.08

975= 9.034%

**Please note, when a bond is quoted with a price of 97.50, it is saying that its current price is trading at 97.50% of par value. NOT $97.50

Example

• Suppose you are considering between 2 bonds. The first bond is a “new” bond, being issued with a stated coupon rate of 12% at par value. This bond matures in exactly 12 years.

• The second bond is an old bond. It’s quoted coupon rate is only 8%. It has exactly 14 years to maturity.

• How much would you be willing to pay for the old bond?

• Let ‘x’ be the purchase price of the bond.

.12 = ($1000 x 8%) + ($1000 – x)/14 yrs x

.12x = $80 + ($1000 – x)/141.68x = $1120 + $1000 – x2.68x = $2120x = $791.04

Why is this bond selling for less than par value???

Short Selling

Important Points

- When you “Short Sell” you are essentially selling something that does not belong to you

-This means you are receiving cash (cash inflow)

- When an investor decides to make a short sell, he/she is speculating that the price of a stock will fall in value, such that he/she can buy the stock back cheaper and return to the owner at a later date and keep the difference between the two prices in profit

- The broker requires that the total amount on deposit (cash in account) must be at least 150% the current market value of the stocks shorted.

-This means that at the time of the short sell, must put up 50% of the value of the stocks shorted! -The remaining 100% needed comes from the value of the

shares themselves

Short Selling - Continued

Important Points - Continued

- When the stock price of the shares that were shorted rise, the investor will be required to deposit additional funds (short call) such that the amount of cash in the account is equal to 150% of the current market value.

- When the stock price of the shares that were shorted fall, the amount of cash in the account is now greater than the 150% that is required. The investor may choose to

withdraw any excess cash from the account

Short Sales

Steps for Success!• Number of shares sold short

multiplied by current BID price to get proceeds from short sale

• Deposit 50% of proceeds from short sale

• To cover short, buy back shares at current ASK price

• Subtract cost of cover from proceeds from short

• Subtract commission in and out to get total profit (loss) from short sale

Short Call- The price of the stock has risen, instead of fallen

- Not a good thing during a Short Sale - Thus, amount on deposit with the broker is less than

150% of the CMV of the stock shorted; therefore Short Call is applied

- Multiply the new price of the shares by the # of shares you shorted. Multiply this amount by 150% to determine how much SHOULD be on account

- Remind yourself how much is currently on accountCurrently in account = Proceeds from Short Sale + Deposit + Previous Short Calls

Short Call - Continued

-The amount of the short call is equal to:

Short Call = Cash Required in account – Cash Currently in Account

Quick Example to illustrate:

Suppose you sold short $10,000 worth of a stock. Your initial security deposit was $5,000 (50%). If the value of the stock you shorted climbs to $20,000, then correct illustration of how to calculate the short call is:

Short- Selling ExampleApril 1st, 2010:

Your mom decides to short sell 1000 shares of LLL-T. The most recent quote on LLL-T is BID: $30.00 ASK: $30.10.

June 1st, 2010:

The price of of LLL-T is now at $35.00/sh. Your mom receives a short call.

July 1st, 2010:

Your mom decides to cover her short position. LLL-T is currently trading for BID: $25, ASK:$26.

a) How much is the short call? b) What is her profit/loss? c) What is the cash balance in her short account after covering?

Short- Selling Example

a) How much is the short call? Apr 1st:

Sell: 1000 @ $30.00 (Bid) = $30,000

Deposit (50%) = $15,000

Cash in Account: $45,000

June 1st: (Price of LLL-T rises to $35)

CMV of Shares (1000 @ $35) = $35,000

Am’t Required (150% of CMV) = $52,500

Amount of Short Call = Amount Req’d – Amount in Account

= $52,500 - $45,000

= $7,500


b) What is her profit/loss?

July 1st:

Sell: 1000 @ $30.00 (Bid) = $30,000

2% out: = $600

Buy: 1000 @ $26.00 (Ask) = $26,000

2% in: =$520

Capital Gain: $2,880

Therefore, her total profit on the short sale is $2,880.


c) What is the cash balance in her short account after covering?

Cash Balance on July 1st, 2010

Proceeds from short Sale: $30,000

Plus: Deposit: +$15,000

Plus: Short Call Deposit: +$7,500

Less: Cost of Covering: - $26,000

Less: Commission in (2%) - $520

Cash Balance in Account: $25,980

**Notice how the commission out (2%) was not included? This is because the commission was paid long ago at the time when we entered the short position. Easiest to consider the commission in as a sunk cost that is paid upfront and unrecoverable

Buying on Margin• Buying on Margin is a form of Leverage

– You are borrowing money to make more money!!

• When you buy on margin, you are speculating that the stock price will rise

• Your broker will offer a set margin requirement. The margin requirement might be 80% for example. – This means that you would put up 80% of the total invested, and

he/she would cover the other 20%

• Don’t forget, brokers don’t loan for free, they charge a set interest rate (will be stated)!

• You must meet the stated margin requirement at all times. If the CMV of the stocks you shorted falls, you may be asked to pay a margin call. If the stock price rises, your broker may offer you more margin

Margin Call

• The broker provides a stated margin requirement. It is very important that you follow that requirement!

• If the CMV of the stock that was purchased on margin decreases, the brokers stake in the investment is growing (since the loan is fixed)– Therefore the margin requirement split isn’t being met

• You must pay off some of the loan, such that the terms of the agreement are back as stated (this is the amount of the margin call!)

• When you pay a margin call, you are reducing the amount of the initial loan…..this has interest implications!!

Example

On April 1st, Blythe has $12,000 available and would like to purchase as many shares of UUU-T as possible utilizing full margin from her broker. The margin requirement is 75%, and interest is charged at 10% per year. UUU-T is currently trading for $5.00/share.

On June 1st, the price of UUU-T has fallen to $3.50/share. Blythe receives a margin call from her broker and pays it immediately.

On August 1st, the price of UUU-T is at $8.00 per share. Blythe decides to exit her margin position at this time.

If Blythe is in the highest federal tax bracket, how much is the margin call, and what is the after tax yield on this investment?

Answer

• How much is the Margin call?

April 1st:

0.75x = $12,000

x = $16,000 (amount available, including loan)

Therefore, broker loans Blythe $4,000

$16,000/ $5 = 3,200 shares purchased on margin.

June 1st: UUU-T falls to $3.50/share

$4000 (brokers loan) / $11,200 (CMV of the shares) = 35.71%

The broker is only willing to have a 25% stake, therefore, we must reduce our loan such that he does!

25% = [$4000 – Margin Call] / $11,500

Margin Call = $1,125 **New Loan amount (as of June 1st) = $4,000 - $1,125 = $2,875

Answer

b) What is the after tax yield on this investment?

Sell: 3200 x $8.00 = $25,600

2% Out = $512

Buy: 3200 x $5 = $16,000

2% In = $320

Capital Gain: $8,768

Interest Expense = [10% x $4,000 x (2/12)] + [10% x $2,875 x (2/12)]

= $66.67 + $47.92

= $114.59

Tax Payable = [(50% x $8,768) - $114.59] x 46.41%

= $1,981.43

After Tax Yield = [$8,768 - $114.59 - $1,981.43] / $12,000

= 55.60%

Example #2 – Margin Buy

Suppose on April 1st, 2010, you only had $8,000 and wanted to purchase as many shares of TCK.B-T using full margin available. TCK.B was trading for $5.00 per share at the time. The margin requirement is 80%.

On May 1st, 2010, the price of TCK.B-T rises to $10.00 per share. You instruct your broker to take the excess margin available to purchase some call options.

Determine the excess margin available


April 1st, 2010

$8000 = 0.8x

x = $10,000

Therefore, $2,000 loan.

Purchase $10,000 / $5 = 2,000 shares of TCK.B-T using margin.


May 1st, 2010 (TCK.B @ $10)

CMV of Shares = $20,000

Therefore, brokers stake = $2,000/$20,000

= 10%

*But broker is willing to loan you up to 20% CMV

Determine amount of additional margin available:

0.2 = $2,000 + x

$20,000

Solving for x, x = $2,000

Therefore, you would have $2,000 available to purchase options

Where x = the amount of excess available for withdrawal

Options

• Call option Option to buy stock at a certain price (strike price) in the future– Strike Price of $50

• If current market price is $50 At the Money• If current market price is $60 In the Money• If current market price is $45 Out of the Money

• Put option Option to sell stock at a certain price in the future– Strike Price of $20

• If current market price is $35 Out of the Money• If current market price is $15 In the Money• If current market price is $20 At the Money

• Remember that in a question where you purchase an option and exercise it, there will be 3 instances of commissions– Commissions in, out and on the purchase of the option (your

premium)

• Company issues dividends: Irrelevant, since there is no ownership in the company.

Call Options

• CALL options are a contract whereby the holder of the option has the right to BUY the underline security as a specified price.

• When you purchase a CALL option, you want the price of the underlying security to rise!

• The intrinsic value on a CALL option is:

Intrinsic Value = Max { 0, Stock Price – Strike Price}

Suppose a CALL option on PCA-T is trading for $3.50. The strike price is $32, and the current price of PCA-T is $33.

The intrinsic value = Max { 0, $33 – $32} = $1.00

The time value = $3.50 - $1.00 = $2.50

Example - CALL

• On March 1st, 2010, an investor decides to purchase 10 CALLS on TCK.B with a strike price of $42. The premium on the options is $3.00.

• On April 1st, 2010, TCK.B is trading at $50/share. The investor exercises his/her options at this time.

What is the profit on the call options?

Answer

Profit on Calls:

Sell: 1000 @ $50 = $50,0002% out: = $1,000Buy: 1000 @ $42 = $42,0002% in: = $840Gross Profit: = $6,160Less Premium: = $3,0002% on Premium: = $60Capital Gain: $3,100

Put Options

• PUT options are a contract whereby the holder of the option has the right to SELL the underline security as a specified price.

• When you purchase a PUT option, you want the price of the underlying security to fall!

• The intrinsic value on a PUT option is:

Intrinsic Value = Max { 0, Strike Price – Stock Price}

Suppose a PUT option on PCA-T is trading for $3.50. The strike price is $34, and the current price of PCA-T is $38.

The intrinsic value = Max { 0, $34 – $38} = $0.00

The time value = $3.50 - $0.00 = $3.50

Example - PUT

• Esteban decided to purchase 20 PUT option contracts of TCK.B. The current price of TCK.B is $31.60/share. The PUT option contracts have a strike price of $33.00. The premiums paid on the options reflect intrinsic value + $2.50 time value. Two months later, Esteban exercises his options. At the time of the exercise, TCK.B was trading for $28.50 per share.

What is the profit/loss on the PUT options?

Answer

Premium Paid = $1.40 (intrinsic) + $2.50 time value

= $3.90

Sell: 2000 @ $33 = $66,000

2% out: = $1,320

Buy: 2000 @ $28.50 = $57,000

2% in: = $1,140

Gross Profit: = $6,540

Less Premium: = $7,800

2% on Premium: = $156

Capital Loss: ($1,416)

**Notice that the Capital Loss of $1,416 is better than letting the options expire and losing $7,956!

Combined Problems

• Tips– Keep track of dates, money in account,

money on hand, commissions, etc.– Take it one transaction at a time– Highlight key answers– Be comfortable with basic material as well

as transitions between concepts (ex: use excess in short account to…use additional margin available….)

Combined Problem

• On August 15th, 2010, Sally decides she is going to enter a short position on the stock LLL-T which is currently trading for $12.50/share. She has managed to gather $6,250 to put towards this investment. She shorts as many shares as possible. On September 8th, 2010, LLL-T climbs to $18.00/share. Sally gets a call from her broker indicating she is in violation of the short agreement, and therefore must deposit additional funds in her account. Without hesitation, she makes the minimum deposit necessary. On October 2nd, 2010, LLL-T is now at $22.00/share. Sally receives another short call. She pays it immediately.

On October 18th, LLL-T falls to $8.50/share. She immediately instructs her broker to cover her short position. She then takes the cash balance (net proceeds) in her short account and buys as many TLM-T Nov 23 Calls @ $2.25.

On November 15th, 2010, TLM-T was trading for BID $28.25, ASK $28.30. Sally exercises her options.

If these were the only two investments that Sally made in 2010, what would be her total tax bill if she also earned $79,150 working at RIM during the year?

Answer

August 15th, 2010

Your mom has $6,250. Therefore she can short $12,500 worth of LLL-T WHY?

$12,500 / $12.50 = 1,000 shares shorted.

Sell: 1000 x $12.50 = $12,500

Deposit (50%): = $6,250

Total Am’t In Account: = $18,750

September 8th, 2010 (LLL-T rises to $18.00/sh)

CMV of shares shorted = $18,000

150% x CMV = $27,000

Therefore, first short call of = $27,000 - $18,750 = $8,250

Answer

New Cash Balance in account (As of Sept 8th) = $12,500 + $6,250 + $8,250

= $27,000

October 2nd, 2010 (LLL-T now @ $22)

CMV of Shares Shorted = $22,000

150% CMV: = $33,000

Amount of Short Call = $33,000 - $27,000 = $6,000

October 18th, 2010 (LLL-T @ $8.50)

Sell: 1000 @ $12.50 = $12,500

2% out: = $250

Buy: 1000 @ $8.50 = $8,500

2% in: = $170

Capital Gain: = $3,580 (We will require this information for tax purposes later)

Answer

Cash Balance in Short Account on Oct 18st, 2010

Proceeds from short Sale: $12,500

Plus: Deposit: +$6,250

Plus: Short Call Deposit (1): +$8,250

Plus: Short Call Deposit (2): +$6,000

Less: Cost of Covering: - $8,500

Less: Commission in (2%) - $170

Cash Balance in Account: $24,330

Purchase TLM 23’s @ $2.25

=$24,330/$2.25 = $10,813.33, therefore purchase 108 full contracts!!

Why only 108? Why not 109 or 108.13 options?

Answer

Purchase TLM 23’s @ $2.25

=$24,330/$2.25 = $10,813.33, therefore purchase 108 full contracts!!

“On November 15th, 2010, TLM-T was trading for BID $28.25, ASK $28.30. Your mom exercises her options”.

Exercise the Options

Sell: 10800 @ $28.25 (bid) = $308,100

2% out: = $6,102

Buy: 10800 @ $23.00 = $248,400

2% in: = $4,968

Gross Profit: =$45,630

Less: Premium = $24,300

2% on Premium = $486

Capital Gain: =$20,844

AnswerIf these were the only two investments that your mother made in 2010, what would be her total tax bill if she also earned $79,150 working at RIM during the year?

Capital Gain on Short Sale: = $3,580Capital Gain on Options: = $20,844

Total Capital Gains for 2010: $24,424

Total Taxable Income: $12,212 (50% x $24,424) + $ 79,150 (Employment Income) $91,362

Now, run $91,362 through Tax Tables # 1 – 3 to determine her Total Tax Payable for 2010: Federal Tax Payable = $17,726Provincial Tax Payable = $ 7,183Ontario Surtax Payable = $ 1,375Total Tax Payable for 2010 = $26,284

That’s all folks.

Good-luck on the 111 Midterm!

Any Questions?

BU111 Exam-AID

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