chapter 12 investing in stocks and bonds

© 2008 Thomson South-Western

CHAPTER 12

INVESTING IN STOCKS AND BONDS

12-2

The Risks Of Investing

BusinessFinancialMarketPurchasing PowerInterest RateLiquidityEvent

12-3

Returns from Investing

iCurrent incomeiCapital gainsiInterest-on-interest

12-4

Interest-on-Interest

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

i Utilizes the time value of money concepts presented earlier

12-5

Interest-on-Interest

12-6

The Risk-Return Trade-Off

If you want GREATER RETURN,

you will most likely have to accept GREATER RISK

12-7

The Risk-Return Trade-Off

If you want GREATER RETURN,

you will most likely have to accept GREATER RISK

12-8

The Risk-Return Relationship

12-9

What Makes A Good Investment?

i Future returni Approximate yieldi Desired rate of return

12-10

Investing in Common Stock

i Each share represents equity or part ownership in the company.

i Stock ownership allows the investor to participate in the profits of the firm.

i Stock ownership is a residual; other obligations of company must be paid first.

12-11

The Dow and the NASDAQ, 1996-2006

12-12

–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

12-13

–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

12-14

–Usually paid quarterly.

–Can be paid even when company shows a loss.

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

Dividends

12-15

– Stock dividends are paid in new shares given to current shareholders.

– Cash dividends are most common and most desirable.

Dividends

12-16

EPS =(Net profits after taxes

– Preferred stock dividends paid)Number of shares outstanding

i Earnings per Share (EPS) — amount of net income earned by one share of common stock

Key Measures of Performance

12-17

– 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.

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

Key Measures of Performance

12-18

Types of Common Stock

i Blue-Chip — issued by large, well established companies.– Usually pay dividends, which lends

price stability.– Returns are considered more

dependable and less risky.

12-19

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

i Tech — issued by companies in the technology sector.– Most are either growth or speculative stocks.– Some are blue-chip stocks.

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

Types of Common Stock

12-20

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

i 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.

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

Types of Common Stock

12-21

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

i 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.

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

Types of Common Stock

12-22

– Usually offer greater returns than larger companies.

– Stock prices tend to be less volatile than small caps.

i 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.

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

Types of Common Stock

12-23

– 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.

i Foreign stock — issued by companies from other countries

Market Globalization and Foreign Stock

12-24

Investing in Common Stock

i Advantages– Potential returns– Actively traded and highly liquid– Involve no direct management

i Disadvantages– Risk– Timing of purchases and sales– Uncertainty of dividends

12-25

Investing in Common Stock

12-26

Making the Investment Decision

i Putting a value on stocki The investment club approachi Timing your investmentsi Plow back your earnings

–Dividend reinvestment plan (DRP)

12-27

Dividend Reinvestment Plan

12-28

Investing in Bonds

i Fixed income securityi Interest rates and bond prices move in

opposite directionsi Versatilei Preservation and long-term accumulation of

capital

12-29

Bonds v. Stocks

i Relative to stock, bonds have a lower return

i But, lower risk

12-30

Bonds v. Stocks

12-31

Bond Issue Characteristics

i A bond is loan—the bondholder is lending money to the bond issuer.

i Generally, interest is paid to the bondholder every 6 months.

i The coupon rate is the annual interest rate paid by the bond issuer.

i The maturity date is when the loan ends and the bond issuer repays the principal to the bondholder.

12-32

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

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

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

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

Bond Issue Characteristics

12-33

The Bond Market

i Treasury Bondsi Municipal Bondsi Corporate Bonds

12-34

The Bond Market

i Treasury Bonds – U.S. Treasury obligation with maturity of more than 10 years that pays interest semiannually

12-35

The Bond Market

i Municipal bonds– Issues of states, counties, cities, and other

governmental subdivisions– Interest income is usually free from federal

income tax (tax-free bonds)

12-36

The Bond Market

Municipal bonds:

12-37

The Bond Market

i Corporate bonds– Industrials–Public utilities–Rail and transportation bonds–Financial issues

• First mortgage bonds, convertible bonds, debentures, subordinated debentures, income bonds

12-38

Bond Ratings

i A letter grade is assigned to new bond issues to designate investment quality.

i The lower the rating, the greater the risk of default and the higher the coupon rate which must be offered.

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

12-39

Bond Ratings

12-40

Bond Ratings

12-41

Bond Prices and Yields

i The price of a bond is a function of its coupon, length of maturity, and the movement of market interest rates.

i Premium bondi Discount bond

12-42

Bond Prices

12-43

Bond Yields

i The yield on a bond is the rate of return you would earn if you held the bond for a stated period of time.