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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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risks of investing
RISKS of Investing!




Purchasing Power

Interest Rate



returns from investing
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
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.
after 20 years you receive
After 20 years you receive:


$2,600 total


Interest= $1,600

Original $1,000

investment capital


0 5 10 15 20


use your calculator to calculate your compounded annual return
Use your calculator to calculate your compounded annual return:

Set on 1 P/YR

and END mode:

1000+/- PV

2600 FV

20 N

I/YR 4.9%


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

8 I/YR

20 N

FV $4,661


After 20 years you receive:


$4,661 total


Interest on interest

= $2,061




Interest= $1,600


Original $1,000

investment capital

0 5 10 15 20


the risk return trade off a fundamental investing concept
The Risk-Return Trade-Off:A Fundamental Investing Concept

If you want


you will most likely have to accept



The Risk-Return Relationship:

Commodities and

Financial Futures










Real Estate

Common Stock


3-yr Treasury Notes

U.S. Treasury Bills


what makes a good investment
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
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.


  • 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
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.


(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
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
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
Types of Bonds
  • Treasury Securities
  • Agency Bonds
  • Municipal Bonds
  • Corporate Bonds
  • Zero Coupon Bonds
  • Convertible Bonds
bond ratings
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 ratings1
Bond Ratings:

Investment Grade

Below Investment Grade

reading a bond quote xyz corp 7 15 close 101
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 7 15 close 101
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
Bond Prices
  • The price of a bond is a function of its coupon, length of maturity, and the movement of market interest rates.



example you bought a 1 year 1000 bond at 8 how does a change in the interest rates affect your bond
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
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
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.