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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

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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

= 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.


Example:

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.


After 20 years you receive:

$3,000

$2,600 total

$2,000

Interest= $1,600

Original $1,000

investment capital

$1,000

05101520

Years


Use your calculator to calculate your compounded annual return:

Set on 1 P/YR

and END mode:

1000+/-PV

2600FV

20N

I/YR4.9%


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

8I/YR

20N

FV $4,661


After 20 years you receive:

$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

05101520

Years


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

If you want

GREATER RETURN,

you will most likely have to accept

GREATER RISK!


The Risk-Return Relationship:

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


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?


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.


  • Voting Rights

  • 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.


  • Basic Tax Considerations:

  • 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.


  • Dividends

  • Usually paid quarterly.

  • Can be paid even when company shows a loss.

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


  • Cash dividends are most common and most desirable.

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


  • Assessing Dividends:

  • 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


Key Measures of Performance

  • 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.


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

  • 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.


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

  • 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.


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

EPS =

(Net profits after taxes

– Preferred stock dividends paid)

Number of shares outstanding


  • Price/Earnings Ratio— shows amount investors are willing to pay for $1 of earnings.

P/E =

Market price of the stock

Annual earnings per share

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


  • Beta— 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

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

    • Usually pay dividends, which lends price stability.

    • Returns are considered more dependable and less risky.


  • Growth — 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 — 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 — 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 — 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 — 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

    • 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 par 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:

    • 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.


    • Sinking Fund

    • 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

    • Treasury Securities

    • Agency Bonds

    • Municipal Bonds

    • Corporate Bonds

    • Zero Coupon Bonds

    • Convertible Bonds


    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.


    Bond Ratings:

    Investment Grade

    Below Investment Grade


    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


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

    $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):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


    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!!!


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


    Scenario A:

    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:

    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

    • 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.


    • Current Yield:

    • 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):

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

    • Measures both annual interest incomeand recovery of principal.


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

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

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


    THE END!


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