BU111 Exam-AID

Agenda• Tax

– Employment and Investment• Stocks

– Going long• Bonds

– Yields and Pricing• Short Selling

– Short Call• Margin Buying

– Margin Call• Options

– PUT and CALL• Combined Problem• Keys to Success

Basic Taxation

Steps for Success!• Determine total taxable income• Find applicable Federal, Provincial, and

Surtax tax brackets from tax table• Calculate Federal tax payable• Calculate Provincial tax payable• Calculate Surtax payable, if applicable• Add total Federal, Provincial and Surtax

tax payables together to get Total Tax Payable

Basic Taxation

• $50,500 = Federal Tax + Ontario Tax= [5,763 + 0.22(50500-37178)] + [2,307

+ .0915(50500-35488)]= 5,763 + 2,930.84 + 2,307 + 1,373.60= 12,374.45*No surtax because taxable income is

lower than the surtax threshold.

Marginal Tax Rate

Steps to Success!• Determine total taxable income• Find corresponding Federal,

Provincial and Surtax tax rates from tax table

• Add Federal, Provincial and Surtax tax rates to get Marginal Tax Rate on taxable income.

– Surtax is a percentage of Provincial tax (ex. 56% x 0.1116 = 6.25%)

Tax on Net Capital GainsSteps for Success!

• Calculate Net Capital Gains or Losses– Subtract total Capital Losses from total Capital Gains– Only calculate tax payable on a Net Capital Gain. If

there is a Net Capital Loss, no tax is calculated.

• Calculate amount of Net Capital Gains subject to tax

– Multiply Net Capital Gains by 50%

• Calculate Total Tax Payable on Net Capital Gains subject to tax

– There are two options:• Multiply Net Capital Gains subject to tax by investor’s

Marginal Tax Rate, or:• Multiply Net Capital Gains subject to tax by Federal and

Provincial tax rates. Multiply Provincial tax payable by Surtax rate. Sum Federal, Provincial and Surtax tax payables to get Total Tax Payable on Net Capital Gains.

Example

• Assume that you are an Ontario investor with taxable income from employment of $86,000 in 2007. In the same year, you received $10,000 in capital gains and $4,000 in capital losses. Calculate your tax payable on Net Capital Gains (Losses).

Answer

Step 1: Net Capital Gains= Capital Gains – Capital Losses= 10,000 – 4,000= 6,000Step 2: Net Capital Gains subject to tax= Net Capital Gains x 50%= 6,000 x 50%= 3,000Step 3: Capital Gains Tax Payable= Net Capital Gains subject to tax X Investor’s Marginal Tax Rate = 3,000 x [26% + 11.16% + 11.16 %( 56%)]= 3,000 X 43.41% -> marginal rate= 1302.30

Tax on Interest

Steps for Success!• Calculate total interest received• Multiply total interest received by:

– Marginal tax rate, or:– Federal and Provincial tax rates. Multiply

total Provincial tax payable by Surtax rate. Sum Federal, Provincial and Surtax tax payables to give total tax payable on interest.

Example

• Assume that you are an Ontario investor with taxable income from employment of $86,000 in 2007. In the same year you received an interest cheque of $5,000. Calculate the tax payable on the interest income.

Answer

• Amount of interest received $

5,000• Combined Federal/Provincial Tax Rate

x 43.41%

• Tax Payable

2,170.50

Tax on DividendsSteps for Success!

• Calculate total dividends received.• For Federal Tax Payable:

– Gross up (45%), tax payable, subtract credit (19%)

• For Provincial Tax Payable:– Follow same steps as Federal Tax Payable,

using Provincial Tax Rates (Tax Credit = 6.7%)• Surtax:

– Take Total Provincial Tax Payable and multiply it by the Surtax rate to get Total Surtax Payable

• Sum Total Federal, Provincial and Surtax Tax Payables to get Total Tax Payable on Dividends.

Example

• Assume that you are an Ontario investor with taxable income from employment of $86,000 in 2007. In the same year, you received $10,000 in dividends from your investments. Calculate your tax payable on dividends.

AnswerFederal tax payable:Dividend received 10,000Add: 45% Gross Up (45% x 10,000)

4,500Amount Subject to Tax (Grossed-Up Dividend) 14,500Federal Tax Payable before Credit (14,500 x 26%) 3,770Less: Federal Dividend Tax Credit (19% x 14,500) (2,755)Federal tax payable 1,015

Ontario Tax Payable:Dividend received 10,000Add: 45% Gross Up (45% x 10,000)

4,500Amount Subject to Provincial Tax (Grossed-Up Dividend)

14,500Ontario Tax Payable before Credit (14,500 x 11.16%) 1618.20Less: Ontario Dividend Tax Credit (6.7% x 14,500) (971.50)Ontario tax payable before Surtax 646.70Ontario surtax (646.70 x 56%) 362.15Total Tax Payable on dividends $

2023.85

Effective Tax Rate

• Calculate total tax payable on investment

• Divide this number by total investment return

• Multiply by 100 Tax Payable *100

Investment Return

After-tax Yield

• Subtract total tax payable on investment from total investment return

• Divide this number by total amount invested

• Multiply by 100Investment Return – Tax Payable

Amount Invested

Stocks• Buying Stocks:

– Determine the number of stocks you would like to buy, and multiply that number by the higher of the two quoted prices (the ASK price) to give you the cost of buying the stock.

– Multiply the cost of buying the stocks by the commission rate (usually 2%)

– Add the cost of buying the stocks to the calculated commission to give the total amount paid for the stocks.

• Selling Stocks:– Determine the number of stocks you would like to sell,

and multiply that number by the lower of the two quoted prices (the BID price) to give the profit from selling the stock.

– Multiply the profit from selling the stock by the commission rate (usually 2%)

– Subtract the cost of commission from the profit from selling the stocks to get the total amount received from selling the stock

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 =$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 = $2180.25

BondsSteps 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 5.20% coupon at a price of $97.50. They mature on October 31, 2021. Calculate the rough yield. Assume the bond is purchased Oct 31, 2007 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 0.052) + (1000 – 975)

14 975=53.8

975= 5.52%

• If you could purchase a similar bond at par bearing interest of 6%, how much would you be willing to pay for this bond?

• Let ‘x’ be the purchase price of the Alcan bond..06 = (1000 X .052) + (1000 – x)/14 yrs

X.06x = $52 + ($1000 – x)/14.84x = $728 + $1000 – x1.84x = $728 + $1000X = $939.13

Short Selling

• When you short sell, you are expecting the price of the shares to go down

• Need to keep 150% of the Current Market Value of the shares with your broker

• If the price goes up, you will receive a short call from your broker

• If the price goes down, there will be excess fund in your short account

Short SalesSteps 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 CallSteps for Success!

• The price of the stock has risen, instead of fallen

• Thus, amount on deposit with the broker is less than 150%

• Multiply new price of stock by number of shares short sold to get current value of short sold stock.

• Multiply the current value of short sold stock by 50% to get amount needed on deposit.

• The difference between the current amount on deposit and the amount needed on deposit is the amount of the short call, and must be paid to the broker.

Example

• Sell short 2000 shares of Molson on Feb 1, then you cover your short April 1 when the price drops to $27. The prices on Feb 1st are BID:28.50 and ASK: 30. How much would you make or lose after commissions if the stock climbed to $35.00 on March 1 and you received a short call from your broker at that time? What would be the amount of the short call?

Answer• Proceeds from short sale

2000 X $28.50 = $57 000Commission Out $57 000 x 2% = $1140Deposit additional 50% = $28 500Total amount in short account = $85 500

• March 1 stock rises to $35.00 X 2000 shares = $70 000Total deposit required in short account $70 000 X 150% = $105 000

• Therefore an additional deposit is required.=$105 000 – $85 500 on account=$19 500 Short Call

• Cost of covering position2,000 x $27.00 = $54,000Brokerage In $54000 X 2% = $1080Proceeds minus the Cost of covering short position57000 – 54000= 3,000 Profit before expensesLess: Total Brokerage Costs $2220 made up of (1140 + 1080)=$780 Capital Gain

Buying on Margin

• The margin requirement is the percentage of the total investment that you need to contribute (ie: if the margin requirement is 65%, that means that at least 65% of the total investment must be your own money)– The other 35% of your investment would be

loaned to you by a broker

• Once the shares you bought on margin are sold, must repay loan with interest to your broker– Interest rate given will be an annual interest rate

(unless stated otherwise)

Buying on Margin

• When you buy on margin, you expect the stock’s price to increase in the future.

• If the share price goes down, you will receive a margin call from your broker

Margin CallSteps for Success!

• Calculate the amount of the margin call.– (current market value – loan) + x = Margin requirement (ex.

75%) current market value

or just find the difference between the market values of the two loans once the price drops/– Current Market Value = number of shares you bought

multiplied by current market price of shares– Loan = total amount invested – amount you invested– ‘x’ = amount of the margin call

• Solve for ‘x’. Subtract ‘x’ from loan to get new loan amount.

• Calculate new interest payable– Multiply old loan amount by interest rate and length of time

held (x/365) or (x/12)– Multiply new loan amount by interest rate and length of time

held– Add the two interest payables to get total interest payable.

Example• Your investor Mike Bodkin is asking you to

invest $85,000 of your money in FineMaster Inc. on January 1, 2007 using the full margin you have available. Sell your holdings on June 1, 2007. How much would you have made or lost after interest and commissions if the stock dropped to $16 on April 1, and you receive a margin call from Mr. Bodkin at that time. What would be the amount of the Margin Call? (Assume margin requirement is 75%)

• You can assume:• Broker Payments are 2% in and out• Interest is 3%• January price is $20• June price is $21.50

Answer• Invest $85,000 of your money. Let "x" = the total amount invested.

75% x = $85,000x = $113,333.33Broker advances $113,333.33- $85,000 = $28333.33 (do you use the full loan?)Purchase $113,333.33/ $20 = 5666 (need to round down because can not have .66 or a share)Amount of loan is: $113,320-85,000 = 28,320April 1, stock drops to $16.00 $16.00 x 5666 = $90,656 Minimum Margin Requirement = 75%Therefore, broker willing to loan 25% x $90,656 = $22,664Current Loan = $28,320Therefore, Margin Call for $28,320 - $22,664 = $5,656

Purchase for = $113,320Sell at 5666 x $21.50 = $121,819

$ 8499• Brokerage Costs

2% In x $113,320 = $2,266.402% Out x $121,819.00 = $2,436.38

$ 4,702.78Capital Gain = $8499- $4,702.78 = $3,796.22Interest Cost 3% x $28,320 x 3/12 = $212.40+ 3% x $22,664 x 2/12 = 113.32

• $ 3,470.50

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

OptionsSteps for Success!

• Buying a CALL – want prices to rise– Multiply premium of shares by number

bought to get cost of option– Add Commission In– To exercise the CALL, buy at strike– Add Commission In– Sell at current market BID– Subtract Commission Out– Subtract cost of market buy and cost

of option from proceeds from sale

Example - CALL

• On February 20 the price of XYZ shares is $30. You expect the price of the shares will increase (bull market), but you would like to get the best possible leverage on your investment. You therefore purchase 7 XYZ May/32 Calls@ 10. On March 12 the stock hits a low of $24. On April 30 the stock hits a high of $42. How much will you gain/lose on this investment if you exercise your option on April 30?

Answer

• March 12 – price falls to $24 – do nothing • April 30 – price rises to $42 – exercise call

Buy @ striking price $32 x 700 = $22 400 Sell in market $42 X 700 = $29 4002% In = $4482% Out = $588Premium = $10/share X 700 shares = $70002% on premium = $112

• TOTAL LOSS = ($1148)• Loss is minimized – would have lost $7112 (premium

+ 2% commission on premium) if not exercised.

OptionsSteps for Success!

• Buying a PUT – want prices to fall– Multiply premium of shares by number

bought to get cost of option– Add Commission In– Buy at current ASK in market– Add Commission In– Sell at strike of PUT– Subtract Commission Out– Subtract cost of market buy and cost of

option from proceeds of strike sale

Example - PUT

• Purchase a 6 month PUT on 100 Shares of Coca-Cola on May 1 at a cost of $2.90 per share. Exercise Nov 1 at the strike price of $26 per share when the current market for that share is $20. How much have you made or lost after all costs have been considered.

Answer• Cost of Put = 100 x $2.90• = $290 + 2% commission $5.80• =$295.80

• Nov 1• Buy in market $20 X 100 = $2000• Brokerage 2% X $2000 =40• Sell to Writer $26 X 100 = $2600• Brokerage 2% X $2600 = 52• Total profit = $2600 - $2000 = $600• Less - $92 brokerage (40 + 52)• Less– 295.80 option cost • Gross Profit= $212.20

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…)

Combined Problem• On February 1st I decide to invest my first paycheck of $3000 on

as many Smirnoff 30 Calls as possible. The current share price is $32 and the calls have a time value of $1. On February 18th I receive another paycheck for $3000 and decide to sell short Forwell’s stock which is currently trading at $60 BID, $62 ASK. I sell as many shares as possible. On March 1st Smirnoff rises to $40 and Forwell’s falls to $52. That day I decide to exercise my Calls because I do not feel Smirnoff will rise any higher. I also place a call to my broker and ask him to take the additional money in my short account and use it to buy K-W Flowers on margin (using max broker’s loan). Assume the margin requirement is 85% and interest is 12%. K-W Flowers is currently trading at $25. On April 1st the price of K-W Flowers falls to $23 and I receive a margin call which I meet later that day. On April 10th I decide to cover my short position on Forwell’s when the price falls further to $47. Finally, I decide to get out of the market because all this trading is making me stress, so I decide to sell all the stock I have in K-W flowers on June 1st at the current market price of $28 per share.

• Given that I am in the 22% federal tax bracket and pay 9.15% provincial tax (no surtax), what would I pay in taxes on these investments? (In total, not per investment)

Answer• February 1st – Purchase a Smirnoff 30 Call Option

with your $3000Smirnoff: Smirnoff calls premium = $1 (Time Value) + (32 –

30) = $3# calls = $3000/$300 = 10 calls (1000 shares)

• February 18th – Short Sell with another $3000 when Forwells is at a BID 60 and ASK 62.

Forwells:$3000 = 50% deposit in short accountValue of Shares sold short = $3000 * 2 = $6000# shares sold short = $6000 / $60 = 100 sharesValue of short account = $9000 (6000 + 50%)

• March 1st – Smirnoff high of $40 and Forwell falls to $52

Remember: Smirnoff is a Call Option and Forwell is a short sell

Exercise Your Call: Smirnoff @ 40Buy 1000 shares @ 30(strike price) =

$30,000Sell 1000 shares @ $40 = $40,000Commission in = 600Commission in = 800Premium Cost = 3000Premium Commission = 60Net capital gain = $5540

Also take the excess in your short account (Forwell) and use it to buy K-W Flowers ($25) on margin:

1) FIND EXCESS AMOUNTMarch 1st: Price of Forwell share = $52Value of shares = 100 * $52 = $5200Required in short account = $7,800 (52000 + 50%)

Excess in short account = $9000 - $7800 = 1,200

2) BUY ON MARGIN WITH YOUR EXCESSK-W Flowers: x = total amount invested0.8x = 1,200x = 1500loan = $300 # shares = $1500/$25 = 60 shares

• April 1st – K-W Flowers Price Drops $23 – Margin Call

Value of shares =60 * 23 = $1380Amount broker is willing to loan = 20% *

$1380 = $276Call = 300 – 276 = $24

• April 10th – Forwell cover your short position when price falls to $47

Buy 100 shares @ $47 = $4,700Sold 100 shares @ $60 = $6000Commission in = 94Commission out = 120Net capital gain = $1086

• Sell all the stock I have in K-W flowers on June 1st at the current market price of $28 per share

Sell 60 shares @ $28 = 1680 Bought 60 shares @ $25 = 1500 Commission out = 33.60 Commission in = 30

Net capital gain = $116.40 Interest = 300*0.12*(1/12) + $276*0.12*(2/12) = $8.52

• What taxes would I pay on these investments?Total Capital Gains = $6742.40Taxable capital gains = 6742.4 * 50% = $3371.20 Interest expense = $8.52 Taxable amount = 3371.20 – 8.52 = 3362.68  Marginal tax rate = 22% + 9.15% = 31.15% Tax on investments = 3362.68* 0.3115 = $1047.48

Smirnoff: Smirnoff 30 Calls Smirnoff calls premium = $1 + (32 – 30) =

$3 # calls = $3000/$300 = 10 calls (1000

shares)

March 1 – Smirnoff price @ $40

Buy 1000 shares @ 30 = $30,000 Sell 1000 shares @ $40 = $40,000 Commission in = 600 Commission in = 800 Premium Cost = 3000 Premium Commission = 60 Net capital gain = $5540

Forwells: Short Sell

$3000 = 50% deposit in short account Value of Shares sold short = $3000 * 2 = $6000 # shares sold short = $6000 / $60 = 100 shares Value of short account = $9000

March 1st: Price of Forwell share = $52 Value of shares = 100 * $52 = $5200 Required in short account = $7,800

Excess in short account = 9000 – 7800 = $1,200

April 10th: Buy 100 shares @ $47 = $4,700 Sold 100 shares @ $60 = $6000 Commission in = 94 Commission out = 120

Net capital gain = $1086

K-W Flowers: Margin Buy

x = total amount invested 0.8x = 1,200 (Excess)x = 1500 loan = $300  # shares = $1500/$25 = 60 shares  April 1st price = $23 Value of shares = $1380 Amt broker is willing to loan = 20% * $1380 = $276 Call = 300 – 276 = $24  June 1st price = $28 Sell 60 shares @ $28 = 1680 Bought 60 shares @ $25 = 1500 Commission out = 33.60 Commission in = 30  Net capital gain = $116.40 Interest = 300*0.12*(1/12) + $276*0.12*(2/12) = $8.52