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# CHAPTER 12: INVESTING IN STOCKS AND BONDS - PowerPoint PPT Presentation

CHAPTER 12: INVESTING IN STOCKS AND BONDS. RISKS of Investing!. Business Financial Market Purchasing Power Interest Rate Liquidity Event. Returns from Investing. Current Return— income while you hold the security + Future Return or Capital Gain— gain on the sale of the investment

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### CHAPTER 12: INVESTING IN STOCKS AND BONDS

Financial

Market

Interest Rate

Liquidity

Event

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

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.

Buy an 8%, \$1,000 Treasury bond that matures in 20 years.

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.

\$3,000

\$2,600 total

\$2,000

Interest= \$1,600

Original \$1,000

investment capital

\$1,000

0 5 10 15 20

Years

Set on 1 P/YR

and END mode:

1000+/- PV

2600 FV

20 N

I/YR 4.9%

Scenario 2 return: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/YR

20 N

FV \$4,661

After 20 years you receive return:

\$5,000

\$4,661 total

\$4,000

Interest on interest

= \$2,061

\$3,000

\$2,600

\$2,000

Interest= \$1,600

\$1,000

Original \$1,000

investment capital

0 5 10 15 20

Years

The Risk-Return Trade-Off: returnA Fundamental Investing Concept

If you want

GREATER RETURN,

you will most likely have to accept

GREATER RISK!

The Risk-Return Relationship return:

Commodities and

Financial Futures

Precious

Metals

Options

R

e

t

u

r

n

Real Estate

Common Stock

Bonds

3-yr Treasury Notes

U.S. Treasury Bills

Risk

• 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?

• 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.

• 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.

• 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.

• Usually paid quarterly.

• Can be paid even when company shows a loss.

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

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

• 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

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

• Subtract liabilities and preferred stock from total assets.

• Good if book value steadily increases.

• Good if market value exceeds book value.

• 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.

• 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.

EPS =

(Net profits after taxes

– Preferred stock dividends paid)

Number of shares outstanding

P/E =

Market price of the stock

Annual earnings per share

• High P/E ratio may indicate a stock is overpriced!

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

• 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.

Types of Common Stock return

• Blue-Chip— issued by large, well established companies.

• Usually pay dividends, which lends price stability.

• Returns are considered more dependable and less risky.

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

• 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.

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

• 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.

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

• 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.

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

• 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.

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

• 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.

Investing in Bonds return

• 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.

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

• 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).

Bond Issue Characteristics return:

• 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.

• 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.

• Types of Bonds return

• Treasury Securities

• Agency Bonds

• Municipal Bonds

• Corporate Bonds

• Zero Coupon Bonds

• Convertible Bonds

Bond Ratings return

• 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.

Bond Ratings return:

Reading a Bond Quote: returnXYZ 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

\$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

Reading a Bond Quote (con't): months, orXYZ 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

Bond Prices months, or

• 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!!!

Example months, or: You bought a 1-year, \$1000 bond at 8%. How does a change in the interest rates affect your bond?

Scenario A months, or:

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

• 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 B months, or:

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

• 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).

Bond Yields months, or

• 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.

• 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.

Yield to Maturity (YTM) months, or:

• Annual rate of return if bond is held until maturity.

• Measures both annual interest incomeand recovery of principal.

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

• If bond purchased at a premium, YTM < coupon rate.

THE END! months, or