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 - PowerPoint PPT Presentation

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  • CHAPTER 12:

    INVESTING IN STOCKS AND BONDS

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    RISKS of Investing!BusinessFinancialMarketPurchasing PowerInterest RateLiquidityEvent

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    Returns from InvestingCurrent Returnincome while you hold the security+Future Return or Capital Gain gain on the sale of the investment

    = Total Return on the investment

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    Interest-on-Interest:An Important Element of ReturnInvestment returns must be reinvested in order for compounding to take place!!!

    Utilizes the time value of money concepts presented earlier.

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    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.Example:

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

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    After 20 years you receive:05101520$1,000 Original $1,000 investment capital$3,000$2,000Interest= $1,600$2,600 totalYears

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    Use your calculator to calculate your compounded annual return:Set on 1 P/YR and END mode:

    1000+/-PV2600FV 20N I/YR4.9%

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    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/YR20NFV $4,661

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    05101520$1,000Original $1,000investment capital$4,000$3,000$2,000$5,000Interest= $1,600$2,600Years$4,661 totalInterest on interest= $2,061After 20 years you receive:

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    The Risk-Return Trade-Off:A Fundamental Investing ConceptIf you want GREATER RETURN, you will most likely have to accept GREATER RISK!

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    The Risk-Return Relationship:RiskReturnU.S. Treasury Bills3-yr Treasury NotesBondsCommon StockReal EstateOptionsCommodities andFinancial FuturesPreciousMetals

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    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?

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    Investing in Common StockEach 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.

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    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

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    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:

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    Usually paid quarterly.

    Can be paid even when company shows a loss.

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

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

    Cash dividends are most common and most desirable.

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    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 shareMarket price per shareAssessing Dividends:

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    Key Measures of PerformanceSubtract liabilities and preferred stock from total assets.Good if book value steadily increases.Good if market value exceeds book value.Book Value amount of stockholder funds used to finance the company.

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

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    Reflects the companys management of its assets, operations, and debt.The better the ROE, the better the financial condition and competitive position of the company.Return on Equity the ratio of net income to common equity.

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    EPS =

    (Net profits after taxes Preferred stock dividends paid)Number of shares outstandingEarnings per Share amount of net income earned by one share of common stock.

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    P/E =

    Market price of the stockAnnual earnings per sharePrice/Earnings Ratio shows amount investors are willing to pay for $1 of earnings.High P/E ratio may indicate a stock is overpriced!

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    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.Beta indicator of a stocks price volatility relative to the market.

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    Types of Common StockBlue-Chip issued by large, well established companies.Usually pay dividends, which lends price stability.Returns are considered more dependable and less risky.

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

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    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.

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

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    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.Mid-Cap issued by companies with market capitalization of $15 billion.

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    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.Foreign issued by companies from other countries in the world.

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    Investing in BondsA bond is loanthe 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.

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    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 bondholderusually $1000 on a corporate bond.

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    CollateralSenior 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.Bond Issue Characteristics:

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    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.Sinking Fund

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    Types of BondsTreasury SecuritiesAgency BondsMunicipal BondsCorporate BondsZero Coupon BondsConvertible Bonds

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    Bond RatingsA 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.

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    Bond Ratings:Investment GradeBelow Investment Grade

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    Reading a Bond Quote:XYZ Corp. 715 Close 101XYZ Corporation is the bond issuer.

    7% is the coupon or annual interest rate paid on this bond.

    The amount of annual interest is 7% of the par value, or

    .075 x $1000 = $75

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    $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

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

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    Reading a Bond Quote (con't):XYZ Corp. 715 Close 101Bond 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

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

    Remember:

    INTEREST RATES

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