CHAPTER 12:

INVESTING IN STOCKS AND BONDS

12-2

RISKS of Investing!

BusinessFinancialMarketPurchasing PowerInterest RateLiquidityEvent

12-3

Returns from Investing

Current Return—income while you hold the security

+Future Return or Capital Gain— gain on the sale of the investment

= Total Return on the investment

12-4

Interest-on-Interest:An Important Element of Return

Investment returns must be reinvested in order for compounding to take place!!!

Utilizes the time value of money concepts presented earlier.

12-5

Scenario 1: Spend the income Every year you receive $1000 X

8% = $80 in interest. After 20 years, you have

received $1,600 in total interest.

Example:Buy an 8%, $1,000 Treasury bond

that matures in 20 years.

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0 5 10 15 20

$1,000 Original $1,000 investment capital

$3,000

$2,000Interest= $1,600

$2,600 total

Years

After 20 years you receive:

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Use your calculator to calculate your compounded annual return:

Set on 1 P/YR and END mode:

1000+/- PV2600 FV 20 N I/YR 4.9%

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Scenario 2: Reinvest the income

Use your calculator to find what you would end up with if you indeed earned an 8% compounded annual return:

1000+/- PV 8 I/YR20NFV $4,661

12-9

0 5 10 15 20

$1,000Original $1,000investment capital

$4,000

$3,000

$2,000

$5,000

Interest= $1,600$2,600

Years

$4,661 totalInterest on interest= $2,061

After 20 years you receive:

12-10

The Risk-Return Trade-Off:A Fundamental Investing

Concept

If you want GREATER RETURN,

you will most likely have to accept GREATER RISK!

12-11The Risk-Return Relationship:

Risk

Return

U.S. Treasury Bills3-yr Treasury Notes

Bonds

Common StockReal Estate Options

Commodities andFinancial Futures Precious

Metals

12-12

What makes a good investment? Know your desired level of risk. Consider potential investments. Compare their returns with those of

like investment types. Do the returns on the investments you

are considering meet or exceed the returns expected for this type of investment?

12-13

Investing in Common Stock Each share represents equity or part

ownership in the company. Stock ownership allows the investor

to participate in the profits of the firm. Stock ownership is a residual; other

obligations of company must be paid first.

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–Usually one share = one vote.

–Most small shareholders assign their votes to a proxy, another party who will vote for them.

–Voting rights are not particularly important to small shareholders.

Voting Rights

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–Short-term capital gains (sale of securities held less than one year) are taxed at regular income tax rates, which go up to over 30%.–Cash dividends and long-term capital

gains (sale of securities held longer than one year) are taxed at a maximum rate of 15%.–Gains are not taxed until realized.

Basic Tax Considerations:

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–Usually paid quarterly.

–Can be paid even when company shows a loss.

–Paid either in cash or in additional shares of stock.

Dividends

12-17

–Stock dividends are paid in new shares given to current shareholders. Does not represent an increase of ownership because all stockholders receive same percentage.

–Cash dividends are most common and most desirable.

12-18

–Dividend Yield measures dividends received relative to market price of stock.

–Compare stocks based on dividend yield rather than dollars received if you are investing for current income.

Dividend Yield =Annual dividends per share

Market price per share

Assessing Dividends:

12-19

Key Measures of Performance

–Subtract liabilities and preferred stock from total assets.–Good if book value steadily

increases.–Good if market value exceeds book

value.

Book Value — amount of stockholder funds used to finance the company.

12-20

–Relates net profit to sales.–The higher the net profit, the more

money the company earns.–Stable or increasing net profit

margins are good signs.

Net Profit Margin — one of the most widely used measures of performance.

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–Reflects the company’s management of its assets, operations, and debt.–The better the ROE, the better the

financial condition and competitive position of the company.

Return on Equity — the ratio of net income to common equity.

12-22

EPS =

(Net profits after taxes– Preferred stock dividends paid)

Number of shares outstanding

Earnings per Share — amount of net income earned by one share of common stock.

12-23

P/E =

Market price of the stockAnnual earnings per share

Price/Earnings Ratio — shows amount investors are willing to pay for $1 of earnings.–High P/E ratio may indicate a stock

is overpriced!

12-24

–The market is used as a benchmark of performance and is assigned a beta of 1. –Stocks with betas < 1 are relatively

less volatile in price swings.–Stocks with betas > 1 are relatively

more volatile in price swings.

Beta — indicator of a stock’s price volatility relative to the market.

12-25

Types of Common Stock Blue-Chip — issued by large,

well established companies.–Usually pay dividends, which

lends price stability.–Returns are considered more

dependable and less risky.

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–Usually pay low or no dividends.– Typically experience more price

volatility.

Tech — issued by companies in the technology sector.–Most are either growth or speculative

stocks.–Some are blue-chip stocks.

Growth — issued by companies expected to have above average rates of growth in operations and earnings.

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–Pay relatively high dividends.–Attractive to people who seek current

income. Speculative — issued by companies

which are considered to have higher risk.– The company, its products, or the

industry may be new or unproven.–Stock prices may be highly volatile.

Income — issued by companies which have a fairly stable stream of earnings.

12-28

–Most are found in basic industries.–Always have a positive beta.

Defensive — issued by companies whose stock prices usually remain stable during economic downturns.–Companies usually provide basic

needs, such as consumer goods.–Betas are usually low or even negative.

Cyclical — issued by companies whose stock prices move in same direction as the business cycle.

12-29

–Usually offer greater returns than larger companies.–Stock prices tend to be less volatile than

small caps.

Small Cap — issued by companies with market capitalization of $1 billion or less. –Offer possibility of high returns.–Prices can be very volatile due to high

risk exposure.

Mid-Cap — issued by companies with market capitalization of $1–5 billion.

12-30

–Offer investors greater portfolio diversity.–Major markets in Japan, United Kingdom,

Germany, France, and Canada.–Other emerging markets around the world.– International mutual funds and American

Depositary Receipts (ADRs) provide convenient ways to invest in foreign securities.–Currency exchange rates can impact

returns on investments.

Foreign — issued by companies from other countries in the world.

12-31

Investing in Bonds A bond is loan—the bondholder is

lending money to the bond issuer. Generally, interest is paid to the

bondholder every 6 months. The coupon rate is the annual interest

rate paid by the bond issuer. The maturity date is when the loan

ends and the bond issuer repays the principal to the bondholder.

12-32

Regardless of the market price paid for the bond, the bondholder will receive the par value at maturity.

Bonds offer current income during the time the bonds are held.

If sold before maturity, bonds can also generate capital gains (losses).

The par value is the amount of principal that must be repaid to the bondholder—usually $1000 on a corporate bond.

12-33

Collateral–Senior or Secured Bonds are backed

by a legal claim on specific property which could be liquidated and used to pay the bondholders if the issuer defaults.

–Junior or Unsecured Bonds are backed only by the promise of the issuer. Debentures are a form of unsecured debt.

Bond Issue Characteristics:

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–Some bond provisions stipulate a repayment schedule detailing how the issuer is to set aside money to repay the principal.

Call Feature

–Bond provisions must state if the bond can be called prior to maturity, and if so, under what conditions.

Sinking Fund

12-35

Types of Bonds

Treasury Securities Agency Bonds Municipal Bonds Corporate Bonds Zero Coupon Bonds Convertible Bonds

12-36

Bond Ratings A letter grade is assigned to new bond

issues to designate investment quality. The lower the rating, the greater the

risk of default and the higher the coupon rate which must be offered.

Outstanding bonds are also reviewed regularly to ensure that their ratings are still valid.

12-37Bond Ratings:Moody’s S&Ps DescriptionAaa AAA Highest ratingAaAA

AAA

High-grade

Baa BBB Medium-grade—lowest of theinvestment grade bonds

BaB

BBB

Junk bonds—highlyspeculative

CaaCaC

CCCCCCD

Poor-quality—in default orvery close to it

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12-38

Reading a Bond Quote:XYZ Corp. 7½15 Close 101

XYZ Corporation is the bond issuer. 7½% is the coupon or annual

interest rate paid on this bond. The amount of annual interest is 7½

% of the par value, or

.075 x $1000 = $75

12-39

$75 2 = $37.50 This bond matures in 2015, so the

last payment to the bondholder should consist of the last interest payment plus the principal amount, or

$37.50 + $1000 = $1,037.50

The bondholder should receive half of the interest every 6 months, or

12-40

Reading a Bond Quote (con't):XYZ Corp. 7½15 Close 101

Bond prices are not quoted in dollars but as a percent of par.

This bond's closing price (or last price) was 101% of par, or

1.01 x $1000 = $1,010

12-41

Bond Prices The price of a bond is a function of its

coupon, length of maturity, and the movement of market interest rates.

Remember:INTEREST RATES AND BOND PRICES MOVE IN OPPOSITE DIRECTIONS!!!

12-42

Example:

You bought a 1-year, $1000 bond at 8%. How does a

change in the interest rates affect your bond?

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If you wish to sell your bond, no one would pay $1000 for your 8% bond because it pays less interest than the new 9% bond.

You must decrease the price of your bond (sell it at a discount) in order to attract a buyer.

Scenario A:

Interest rates RISE and comparable new bonds are now issued at 9%.

12-44

If you wish to sell, your 8% bond is now very attractive because it pays higher interest than new 7% bonds.

You would be able to increase the price of your bond (sell it at a premium).

Scenario B:

Interest rates FALL and comparable new bonds are now issued at 7%.

12-45

Bond Yields The yield on a bond is the rate of

return you would earn if you held the bond for a stated period of time.

The two most commonly cited bond yields are current yield and yield to maturity.

12-46

–Amount of annual interest income relative to the current market price of the bond.–All else being equal, the higher the

current yield, the more attractive the bond.–Essentially the same calculation as

the dividend yield on stocks.

Current Yield:

12-47

Yield to Maturity (YTM):

–Annual rate of return if bond is held until maturity.–Measures both annual interest

income and recovery of principal.

12-48

–If bond purchased at a discount, YTM > coupon rate.–If bond purchased at a premium,

YTM < coupon rate.

–If bond is purchased at face value, YTM = coupon rate.

THE END!