PFIN 4

Investing in Stocks and Bonds

12

Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

GITMAN/ JOEHNK/ BILLINGSLEY

2Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

1 Describe various types of risk to which investors are exposed, as well as the sources of return

2 Know how to search for an acceptable investment on the basis of risk, total return, and yield

3 Discuss the merits of investing in common stock and be able to distinguish among the different types of stocks

LEARNING OUTCOMES

PFIN4 | CH12

3Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4 Become familiar with the various measures of performance and how to use them in placing a value on stocks

5 Describe the basic issue characteristics of bonds as well as how these securities are used as investment vehicles

6 Distinguish between the different types of bonds, gain an understanding of how bond prices behave, and know how to compute different measures of yield

LEARNING OUTCOMES (continued)

PFIN4 | CH12

Risks of Investing

4Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

Risks of Investing

5Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

Returns from Investing

6Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Current income - Received with some degree of regularity over a year

• Capital gains - Reflected as an increase in the market value of an investment vehicle

• Earning interest on interest

PFIN4 | CH12

Exhibit 12.2

7Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. MKTG4 | CH1

The Risk-Return Relationship

Components of a Good Investment

8Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Future return• Approximate yield

• Provides a measure of the fully compounded rate of return from an investment

• Desired rate of return: Minimum rate of return earned in compensation for the amount of risk assumed

PFIN4 | CH12

Exhibit 12.3

9Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. MKTG4 | CH12

Performance of Dow Jones Industrial Average and NASDAQ Composite, 2004 through 2014

Source: Morningstar 2013.

Investing in Common Stock

10Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Issuers of common stock• Issued by any corporation in any line of

business• Voting rights - For each share of stock held

holders receive one vote• Proxy: Written statement used to assign a

stockholder’s voting rights to another person• Basic tax considerations

• Common stocks provide income in the form of dividends and/or capital gains

PFIN4 | CH12

Dividends

11Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Paid by firms to their common stock holders in cash and/or additional stock

• Dividend yield: Percentage return provided by the dividends

• Stock dividends• New shares of stock distributed to existing

stock holders as a supplement for cash dividends

PFIN4 | CH12

Key Measures of Performance

12Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Book value: Amount of stockholder’s equity in a firm

• Net profit margin: Relates a firm’s net profits to its sales

• Return on equity (ROE): Captures the firm’s overall profitability

PFIN4 | CH12

Key Measures of Performance

13Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Earnings per share (EPS): Return earned by each share of common stock

• Price/earnings (P/E) ratio: Measure of investors’ confidence in a given security

• Beta: Index of the price volatility for a share of common stock

PFIN4 | CH12

Types of Common Stock

14Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

Types of Common Stock

15Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

Reasons for Investing in Common Stock

16Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Using the stock as a warehouse of value• Accumulating capital• Providing source of income

PFIN4 | CH12

Stock Ownership

17Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Advantages• Potential returns• Actively traded and are highly liquid form of

investment • Available market and company information

• Disadvantages• Risk• Problem of timing purchases and sales• Uncertainty of dividends

PFIN4 | CH12

Making the Investment Decision

18Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Putting a value on stock• Timing the investments• Being sure to gain earnings

• Dividend Reinvestment Plan (DRP): Allowing stockholders to take their cash dividends in the form of more shares of the firm's stock

PFIN4 | CH12

Types of Bonds

19Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Coupon: Defines the annual interest income paid to bondholder by the issuer

• Types of issues• Mortgage bond: Secured by a claim on real

assets• Equipment trust certificates: Secured by certain

types of equipment

PFIN4 | CH12

Basic Issue Characteristics of Bonds

20Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Debentures: Unsecured bond issued on the general credit of the firm

• Sinking fund: Specifies the annual repayment schedule to be used in paying off the issue

• Call feature: Allows the issuer to retire the security prior to maturity

PFIN4 | CH12

Bond Market

21Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Treasury bond• Issued and backed by the full faith and credit of

the U.S. government• Treasury inflation-indexed bond (TIPS): Principal

payments adjusted to provide protection against inflation

• Agency bond• Obligation of a political subdivision of the U.S.

government

PFIN4 | CH12

Bond Market

22Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Mortgage-backed securities• Claim on the cash flows generated by mortgage

loans• Municipal bonds: Issued by state or local

governments• Serial obligations: Issue broken down into a

series of smaller bonds with own maturity date and coupon rate

PFIN4 | CH12

Bond Market

23Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Revenue bonds: Serviced from the income generated by a specific project

• General obligation bonds: Backed by the full faith and credit of the issuing municipality

• Corporate bonds: Issued by a corporation

PFIN4 | CH12

Bond Market

24Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Convertible bonds• Conversion privilege: Stipulates the conditions of

the conversion feature • Conversion ratio: Specifies the number of shares

of common stock into which a convertible bond can be converted

PFIN4 | CH12

Bond Market

25Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Conversion value: Measure of what a convertible issue would trade for if it were priced to sell based on its stock value

• Conversion premiums: Difference between a convertible security’s market price and its conversion value

PFIN4 | CH12

Exhibit 12.2

26Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. MKTG4 | CH12

Moody’s and Standard & Poor’s Bond Ratings

Pricing a Bond

27Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

• All bonds are priced as a percentage of par• Priced in decimals in the corporate and

municipal market• Accrued interest: Amount of interest

earned since the last coupon payment date by the bond holder/seller• Clean Price: Quoted price of a bond minus

accrued interest• Dirty Price: Quoted price of a bond plus

accrued interest

Bond Prices and Yields

28Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

• Bond price depends on its:• Coupon• Maturity• Movement of market interest rates

• Premium bond: Market value is higher than par

• Discount bond: Market value is lower than par

Bond Prices and Yields

29Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PFIN4 | CH12

• Current yield• Amount of current income a bond provides

relative to its market price• Yield to maturity

• Fully compounded rate of return that bond would yield if held to maturity

30Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Business risk• Financial risk• Market risk• Purchasing power risk• Fixed income

securities• Interest rate risk• Liquidity risk• Event risk• Risk-free rate of

return• Desired rate of return• Residual owners

KEY TERMS

• Proxy• Dividend yield• Stock dividends• Book value• Net profit margin• Return on equity

(ROE)• Earnings per share

(EPS)• Price/earnings (P/E)

ratio

PFIN4 | CH12

31Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Beta• Blue-chip stock• Growth stock• Tech stock• Income stock• Speculative stock• Cyclical stock• Defensive stock• Large-cap stock• Mid-cap stock• Small-cap stock

KEY TERMS• Dividend

reinvestment plan (DRP)

• Coupon• Mortgage bond• Equipment trust

certificate• Debenture• Sinking fund• Call feature• Treasury bond• Treasury inflation-

indexed bond (TIPS)PFIN4 | CH12

32Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

• Agency bond• Mortgage-backed

securities• Municipal bond• Serial obligation• Revenue bond• General obligation

bond• Corporate bond• Conversion privilege• Conversion ratio

KEY TERMS

• Conversion value• Conversion premium• Junk bond• Accrued interest• Clean price• Dirty (full) price• Premium bond• Discount bond• Current yield• Yield to maturity

PFIN4 | CH12

33Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SUMMARY

• Investors are exposed to business, financial, market, purchasing power, interest rate, liquidity, and event risks• Sources of return - Current income, capital

gains, and interest• An investment is acceptable only if it is

expected to generate a rate of return meets one’s desired rate of return

• Types of stock• Blue-chip, growth, tech, income, speculative,

cyclical, defensive, and market-cap PFIN4 | CH12

34Copyright ©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

SUMMARY

• Measures of performance• Book-value, net-profit margin, ROE, EPS, P/E

ratio, and beta• Bonds are referred to as fixed-income

securities as the debt service obligations of the issuer are fixed

• Types of bonds• Treasury, agency, mortgage-backed,

municipal, corporate, and convertible

PFIN4 | CH12