CHAPTER 12 INVESTING IN STOCKS AND BONDS

1. CHAPTER 12INVESTING IN STOCKS AND BONDS

2. The Risks Of Investing Business Financial Market Purchasing Power Interest Rate Liquidity Event

3. Returns from Investing • Current income • Capital gains • Interest-on-interest

4. Interest-on-Interest • Investment returns must be reinvested in order for compounding to take place • Utilizes the time value of money concepts presented earlier

5. Interest-on-Interest

6. The Risk-Return Trade-Off If you want GREATER RETURN, you will most likely have to accept GREATER RISK

7. The Risk-Return Trade-Off If you want GREATER RETURN, you will most likely have to accept GREATER RISK

8. The Risk-Return Relationship

9. What Makes A Good Investment? • Future return • Approximate yield • Desired rate of return

10. 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.

11. The Dow and the NASDAQ, 1996-2006

12. 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

13. 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.

14. Dividends • Usually paid quarterly. • Can be paid even when company shows a loss. • Paid either in cash or in additional shares of stock.

15. Dividends • Stock dividends are paid in new shares given to current shareholders. • Cash dividends are most common and most desirable.

16. Key Measures of Performance EPS = (Net profits after taxes – Preferred stock dividends paid) Number of shares outstanding • Earnings per Share (EPS)— amount of net income earned by one share of common stock

17. Key Measures of Performance • 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.

18. 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.

19. Types of Common Stock • 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.

20. Types of Common Stock • 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.

21. Types of Common Stock • 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.

22. Types of Common Stock • 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.

23. Market Globalization and Foreign Stock • Foreign stock — issued by companies from other countries • Offer investors greater portfolio diversity. • International mutual funds and American Depositary Receipts (ADRs) provide convenient ways to invest in foreign securities. • Currency exchange rates can impact returns on investments.

24. Investing in Common Stock • Advantages • Potential returns • Actively traded and highly liquid • Involve no direct management • Disadvantages • Risk • Timing of purchases and sales • Uncertainty of dividends

25. Investing in Common Stock

26. Making the Investment Decision • Putting a value on stock • The investment club approach • Timing your investments • Plow back your earnings • Dividend reinvestment plan (DRP)

27. Dividend Reinvestment Plan

28. Investing in Bonds • Fixed income security • Interest rates and bond prices move in opposite directions • Versatile • Preservation and long-term accumulation of capital

29. Bonds v. Stocks • Relative to stock, bonds have a lower return • But, lower risk

30. Bonds v. Stocks

31. Bond Issue Characteristics • 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.

32. Bond Issue Characteristics • 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.

33. The Bond Market • Treasury Bonds • Municipal Bonds • Corporate Bonds

34. The Bond Market • Treasury Bonds – U.S. Treasury obligation with maturity of more than 10 years that pays interest semiannually

35. The Bond Market • Municipal bonds • Issues of states, counties, cities, and other governmental subdivisions • Interest income is usually free from federal income tax (tax-free bonds)

36. The Bond Market Municipal bonds:

37. The Bond Market • Corporate bonds • Industrials • Public utilities • Rail and transportation bonds • Financial issues • First mortgage bonds, convertible bonds, debentures, subordinated debentures, income bonds

38. 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.

39. Bond Ratings

40. Bond Ratings

41. Bond Prices and Yields • The price of a bond is a function of its coupon, length of maturity, and the movement of market interest rates. • Premium bond • Discount bond

42. Bond Prices

43. 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.