Why do Companies Issue Stocks and Bonds?

To obtain capital (money) to complete the necessary activities of a business and expand, a company uses either equity or debt financing

Equity Financing – issuing stock to investors An investor pays a company the price for the stock and, in

return, obtains partial ownership of the company Debt Financing – obtaining loans or issuing bonds in

order to fund investments

Equity FinancingTypes of Stocks

Elect the board of directors Vote in annual shareholder’s meeting Generally exercise control of the

company

If company goes bankrupt, common stockholders get paid last

Not guaranteed dividend payments

Rights of Common Stockholders Limitations of Common Stockholders

Common StockOwnership of a share of publicly-traded company

Investments in common stock appreciates as the company’s earnings grow

If company pays dividends, preferred stockholders will be paid before common stockholders

Preferred stockholders have a greater claim on company’s assets if the company liquidates

Have no voice in how the company is managed

No voting rights

Rights of Preferred Stockholders Limitations of Preferred Stockholders

Preferred StockHybrid between a stock and a bond

Represents equity/ownership in a corporation, but to a limited degree

Stock Categorization1. Industry

Examples: Consumer Goods

ConAgra, General Mills

Personal Computers Apple, Dell

Stock Categorization2. Market Capitalization

Total market value of all of a company’s outstanding shares

Large-cap: securities issued by companies that have a market capitalization value of more than $10 billion

Mid-cap: securities issued by companies that have a market capitalization value between $2 and $10 billion

Small-cap: securities issued by companies that have a market capitalization value between $300 million and $2 billion

WMT MSFT GE

Market Cap Shares Outstanding Share Pricex=

Stock Categorization2. Market Capitalization

Total market value of all of a company’s outstanding shares

Example:Company ABC has a share price of $15 per share and has 20,000 shares outstanding. The market capitalization is 20,000 x $15 = $300,000,000.Therefore, Company ABC is considered a small cap

company.

The “Key Statistics” section on YahooFinance will show you the company’s market cap of the stock you look up.

Market Cap Shares Outstanding Share Pricex=

Stock Categorization3. Company’s Sensitivity to the Business Cycle

Describes different stages of growth and decline in an economy

Peak: Economic activity is growing rapidly and production facilities are operating at full capacity

Contraction: Economy begins to slow down, unemployment rises, consumer spending declines, and sales decline

Trough: Economy is at the lowest point on the business cycle Recovery: Employment levels and sales start to increase

again Expansion: A period when business activity surges and the

GDP expands until it reaches a peak (also known as an economic recovery)

Recession Recovery Expansion

Stock Categorization

Peak

0%

5%

-5%

GD

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row

th

Trough

Previous Peak Broken

3. Company’s Sensitivity to the Business Cycle Describes different stages of growth and decline in an

economy

Business CycleWhat determines a Company’s

Sensitivity to the Business Cycle?

1. Defensive vs. Cyclical Stocks2. Operating Leverage3. Financial Leverage

Business Cycle1. Defensive vs. Cyclical Stocks

Defensive Stock: not greatly affected by the business cycle. This is because defensive stocks are in industries such as food, utilities, and other consumer goods that are not considered “necessities”. Defensive stocks do not increase in price when the market surges or declines. Example: ConAgra Foods

Business Cycle1. Defensive vs. Cyclical Stocks (cont)

Cyclical Stocks: largely affected by the business cycle. Cyclical stocks will decrease when the market is weak and increase when the market is favorable. Examples: Auto Makers (Ford), Airline Companies (Jet Blue Airlines)

What are some reasons airlines and auto-makers are cyclical companies?

Business Cycle2. Operating Leverage Measures the amount of operating risk associated with a company’s

level of fixed costs compared to its variable costs. The greater the percentage of fixed costs to total expenses, the

higher a company’s degree of operating leverage.

Fixed Costs Costs that do not change with the level of production. Examples of fixed

operating costs include salaries, insurance expenses, and rent because regardless of how much you produce, these costs will not change.

Variable Costs Costs that change with the level of production. Examples include the costs

of goods sold or sales. Generally the larger the production, the less each individual product costs to make because of “economies of scale”.

An Option’s Intrinsic Value Example:

Sky High Airlines has a high level of operating leverage. Aircraft and gate costs at airports are very large fixed costs incurred by Sky High Airlines.Regardless of how sales do, these costs do not change.Therefore, when sales increase, the variable costs will increase but to a

lesser degree.These costs are comprised of fuel and maintenance of the planes.Sky High Airlines’ operating leverage would decrease because its

percentage of fixed costs to total cost is not as large during an increase in sales.

Fixed Costs = $15 millionVariable Costs (low sales) = $18 million

Variable Costs (high sales) = $25 million

Operating Leverage (low sales) = 15/(15+18) = 45.5%Operating Leverage (high sales) = 15/(15+25) = 37.5%

Business Cycle3. Financial Leverage A way for a company to gain large returns without investing a lot of

capital. Firms with a high degree of financial leverage are more sensitive to the business cycle.

Leverage = Debt/Equity

As you will learn in the next section, debt financing uses capital from outside the company to finance an investment, whereas equity financing comes from selling shares of ownership of the company.

Debt FinancingParts of a Bond Principal – the face value of the bond Maturity – the established time for the issuer to repay

the bond Coupon – the interest payments of a bond (usually

every 6 months) Yield – the rate of return realized from investing in the

bondThe term coupon comes from the early days of bonds. The physical paper bond was a certificate with coupon tickets that, when brought to the issuer, could be redeemed for the interest payment. Owners of the bond would clip the coupons in order to obtain their interest payments.

Who Issues Bonds and Why?Governments The U.S. Government issues Treasury bonds in order to pay for

government activities and to pay off government debt. Treasury bonds are backed by the “full faith and credit” of the U.S.

Government. Thus, these bonds are essentially free from default risk.

Government BondsU.S. Government Issued Bonds

Maturities: 4 weeks, 13 weeks, 26 weeks, and 52 weeks Face value: $1,000 Purchased at a discount and the full amount is repaid at maturity

Treasury Bills

Maturities: over 1 to 10 years Issued in denominations of $1,000 to $5,000 Coupons paid semi-annually

Treasury Notes

Maturities: over 30 years Denominations: $1,000 to $1 million Coupons paid semi-annually

Treasury Bonds

Agencies Organizations that are wholly owned and supported by

the government Issue bonds that have a direct government guarantee Housing agencies are the most active issuers of bonds,

among all agencies Example: Government National Mortgage Association (GNMA), known

as Ginnie Mae, is a U.S. housing agency.

Government Sponsored Enterprise (GSE’s)

Organizations that have an implied government guarantee but are not directly owned by the government Example: Federal Home Loan Mortgage Corporation (FHLMC), known

as Freddie Mac and Federal National Mortgage Association (FNMA) commonly known as Fannie Mae

GSE implies that the enterprise’s bonds are less risky than other bonds because the government would not allow them to fail because of their “implied” guarantee

MunicipalitiesState and local governments issue Municipal bonds to borrow money to build and expand: Schools Government buildings Water, power, and sewage systems Prisons and hospitals Colleges Roads Bridges Public transportation Airports Highways

Why Buy Muni Bonds?

Tax Free Income Interest payments obtained from Municipal Bonds are exempt from

federal tax and from state income tax if you reside in the specific state issuing them

Safe Investment United States Treasuries are the safest and municipals are

considered second

Types of Muni BondsMuMunicipalities – Two Types of Bonds

Issued to raise funds for projects that no not provide direct sources of revenue Examples: Roads, bridges, parks

Issued in order to fund projects that will serve the entire community, not only those who pay for the services

Backed by the full faith and credit of the issuing municipality

Interest and principal are paid through tax receipts

Finance income-producing projects Examples: Airports, Power and Water

municipalities Income generated by these projects

pays the bondholders their interest and principal revenue

Projects that are backed by revenue bonds provide services to only those in the community who pay for their services

General Obligation Bonds (GO) Revenue Bonds

Who Issues Bonds and Why?Corporations Issue long-term debt to expand and finance their activities Pay semi-annual coupons and repay face value of the bond at

maturity Corporate bonds are traded “over the counter”

Different rating agencies exist for bondsBond Ratings

Standard & Poor’s and Moody’s are the two most recognizable rating agencies

Bonds are rated according to their risk Different factors affect the riskiness of a bond, one of the largest

being default risk Default risk is the ability of a company to repay the bond at maturity If there exists a large default risk (more uncertainty the company will

be able to repay its debt), the investor should require a greater return to compensate for the risk it is taking on

CREDIT RATINGS*MOODY’S STANDARD & POOR’S FITCH

INVESTMENT GRADE

STRONGEST Aaa AAA AAA

Aa AA AA

A A A

Baa BBB BBB

NON-INVESTMENT GRADE

WEAKEST

Ba BB BB

B B B

Caa CCC CCC

Ca CC CC

C C C

C D D

*These credit ratings are reflective of obligations with long-term maturities.

Bond Structure

Debenture Bonds – An unsecured, meaning it is not backed by any collateral. It can be a real asset (ex. Building) or a financial asset (ex. Loan or Bond).

Collateralized Bonds – Are backed by either a financial asset or a real asset. In the case of bankruptcy, the assets are sold and the proceeds are used to pay back the holder of the collateralized bonds. Collateralized bonds are safer than debenture bonds and, therefore, offer lower yield.

Debenture vs. Collateralized

Bond Structure

Refers to the currency in which the bond is issued and its coupon and principal payments are paid

The most common currencies are: U.S. Dollars EU Euros Japanese Yen

Currency Denomination

Redemption Characteristics

When a bond issued with a call option, the issuer has the option to retire the bond before maturity at a set price, known as the call price

Issuers exercise call options when interest rates are low and they can refinance at lower interest rates

Callable Bonds

Redemption Characteristics

Gives the bondholder the option to exchange the bond for a set number of shares of common stock in the issuing company

Bond

Bondholder

Common Stock

Convertible Bonds

Redemption Characteristics

A means of repaying funds that were borrowed through a bond issue

The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market

Sinking Fund Bonds

Coupon Structure

Fixed Rate Bond Majority of bonds are fixed rate bonds The coupon rate does not fluctuate

Floating Rate Bond Bonds that have a coupon rate that is adjusted periodically, or “floats”, in

conjunction with a short term rate, such as LIBOR (London Inter-Bank Offer Rate).

The coupon structure is the interest rate stated on a bond when the bond is offered. It is the percentage of the bond that will be paid, usually semi-annually or annually, as the coupon payment to the owner of the bond. The bond will either pay a fixed rate coupon or a floating rate coupon.

Payment of Principal

Balloon Payment Treasuries, Munis, and Corporate Bonds are based off of balloon payments A balloon payment system occurs when small payments are made

throughout the duration of the bond and a large, “balloon” payment is made at maturity

Amortization The process by which the principal balance gradually declines over time and

is at zero at maturity Interest and principal make up a mortgage payment In the beginning of the mortgage, the majority of the payment is interest As the payments continue, a large portion of the payment is made up of

principal repayment and a smaller portion is comprised of interest payment

The bond’s principal can be repaid with a “balloon payment” or through amortization.

Payment of Principal

Mortgage$300,000

$900

$100

Mortgage$290,000

$875

$125

Mortgage$280,000

Mortgage$1,000

Mortgage $0 (repaid)

$0

$1,000

InterestPortion

PrincipalPortion

InterestPortion

PrincipalPortion

InterestPortion

PrincipalPortion

Year 1Payment

Year 2Payment

Year 30Payment

Example: 30 Year Fixed Rate Mortgage $300,000 mortgage with $1,000 yearly payments

Mortgage Backed Securities A type of bond representing an investment in a pool of

real estate loans. This is a way for banks to free up capital to make

additional loans and provide a way for market participants to invest in mortgages.

A pro rata share of the pool is sold to investors as bonds The pooling together of illiquid assets, such as mortgage

loans, and selling off shares in the pool as bonds is known as securitization

Mortgage Backed SecuritiesMortgage 1 Mortgage 3 Mortgage 5 Mortgage 7

Mortgage 2 Mortgage 4 Mortgage 6 Mortgage 8

Pool of Mortgages

MBS MBS MBS MBS MBS

Mortgage Backed Securities

Prepayment Risk The largest risk when investing in a MBS Prepayment occurs when the principal is repaid earlier

than the scheduled maturity of the loan. Often, a borrower will prepay when they want to refinance their mortgage in a lower interest rate environment.

Mortgage Backed Securities Example:

I.N. Vestor wants to buy a house with a purchase price of $500,000.I.N. Vestor approaches his bank to secure a mortgage.He funds the purchase of the house with a 30-year mortgage at a 4%

interest rate.Over the next 30 years, the bank will continue to receive principal and

interest payments from I.N. Vestor.The bank wants to sell the stream of interest (4%) and principal

payments from his loan to other investors.The bank is making money by devising and servicing the mortgages.In order to sell the interest stream to other investors, the bank bundles I.N. Vestor’s loan together with 5,000 other mortgages.Then the bundle, consisting of I.N. Vestor’s loan and the 5,000 other

mortgages, are sold to investment banks as mortgage-backed securities.The investment bank then divides the pool of loans and sells these as

separate bonds to investors.

Stocks vs. BondsCompanies that issue preferred stock are not obligated to pay dividends to their stockholders. Issuers of bonds are required to pay coupons (interest payments) to

their bondholders. Furthermore, if an issuer suspends payment on preferred stock dividends, common stock dividends cannot be paid

Most preferred stock are “cumulative,” that is, if dividends are suspended, the dividends accumulate and must be paid before any common stock dividends are paid

Stocks vs. Bonds “Senior” means that the debt has priority over other

types of debt in the case of bankruptcy.

“Unsecured” means that specific collateral does not exist and, therefore, has a lower priority in the case of bankruptcy.

Stocks vs. BondsIn case of liquidation, a company will pay back its debt in the following order:

Senior Secured DebtThis debt is collateralized. In the event of liquidation, a company will repay this debt FIRST because the loan is backed by real/financial assets.

Senior Unsecured Debt

This debt is not collateralized. Purchasing this form of debt has more risk than senior debt. The senior unsecured debt does not have a specific asset backing the loan. The individual/corporation that purchases this debt will be compensated for taking on more risk by receiving a higher interest rate.

Preferred Stock Preferred shareholders get paid after senior secured and unsecured debt holders but before common shareholders.

Subordinated/Unsecured Debt

Represents a claim on a company’s assets, which is senior only to common shares. This debt is only paid once all senior debt holders have been paid.

Common Stock Owners of common stock are the last to be paid in case of bankruptcy or liquidation.M

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Stocks vs. BondsCollateral An asset that backs the loan If you fail to pay back the loan to the bank, then the lender can liquidate the

collateral to repay the loan

Money Market Instruments

Treasury Bills (sometimes called T-bills) Short-term debt, with a maturity of up to one year Backed by the U.S. government Sold in denominations of $1,000 Maturities of one month, three months, six months, or twelve months

Commercial Paper An unsecured, short-term debt instrument Issued by a corporation Typically for financing of accounts receivable, inventories and meeting

short-term liabilities Maturities range from 1 to 270 days

Money Market Instruments are characterized as debt obligations with maturity up to one year.

Alternatives to Direct Stock Market Investment

Exchange Traded Funds (ETFs)

Closed-ended fund that tracks and index

Can be traded like a stock ETFs are stocks within specific

sectors that mimic the market Example: Spider (SPDR), which

tracks the S&P 500 Index

American Depository Receipts (ADRs)

A way to invest in foreign equity that is considered safer for U.S. investors

U.S. banks keep a certain amount of stock of a foreign company in its vaults (depository)

Investor can buy shares in that collection of stocks, priced in U.S. dollars.

American Depository Receipts (ADR)

ADR Way to invest in foreign equity that is considered safer for U.S.

investors U.S. banks place a certain amount of stock of a foreign

company into its vault (depository) Investors can buy shares in that collection of stocks, priced

in U.S. dollars

Alternatives to direct investment in the stock market

DerivativesA financial instrument (security) that derives its value from an underlying asset. The price of the underlying asset determines the price of the derivative.

Underlying assets include: Stocks Bonds Commodities (gold, cattle, etc.) Exchange rates Indexes (NASDAQ 100)

Why Invest Using Dervatives?Hedging Allow corporations and individuals to protect themselves against

risk. For example, the risk that the stock will decline in value in the future.

Speculation The practice of partaking in risky financial transactions in order to

profit from short- or medium-term fluctuations in the market value of tradable goods such as a financial instruments. In essence, it’s a guess.

Types of DerivativesForwards A forward is a private contract to buy or sell a security at a specific date in

the future at a set price

Futures A future is a financial contract obligating the buyer to purchase an asset (or

the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Future contracts specify the quality and quantity of the underlying asset. Future contracts are standardized to enable trading on a futures exchange.

Futures exchange – The central marketplace where futures contracts and options on futures contracts are traded

Difference between Forwards and Futures

Standardization Trades on an exchange and is subject to standards of the exchange Futures are standardized. Forward contracts are not standardized

Difference between Forwards and Futures

Long Position If you buy a future contract, called buying long, then you have an

obligation to buy the security at a set price at the specific date. That price is called the strike price.

Short Position If you sell the future contract, called selling short, you have the

obligation to sell the security at a set price at the specified date. That price is also called the strike price.

Difference between Forwards and Futures

Example:On August 3rd, I.N. Vestor buys a futures contract to buy

100 shares of Company ABC at $30 per share on October 31st.On October 31st, Company ABC is trading at $15 per

share.I.N. Vestor must pay $15 per share.His loss is $1,500[($30-$15) x 100 shares]

Options

An agreement that gives the investor a choice of whether or not to buy (called a call) or sell (called a put) an asset at the strike price and set time period in the future

There is no contract in place that obligates the investor to exercise the option

Options

Option Premium – Price of the option Strike Price – Price where the owner of an option can

purchase (call), or sell (put) the underlying security Put Option (Put) – Option to sell stock at a specific price

by a specific date in the future. Investors purchase a put if they think that the price of the underlying asset will drop

Call Option (Call) – An option to buy stock at a specific price on a specific date in the future

Expiration Date – The last date that an options or futures contract is valid

An Option’s Intrinsic ValueIn the MoneyIf the current price of the stock is above the call option price, the investor will exercise the option and buy the stock at the strike price. The investor is “in the money” because the investor can then sell the stock at the current price and make a profit.Current Stock Price > Strike Price

An Option’s Intrinsic Value Example:

I.N. Vestor buys a call option on Company ABC stock with a strike price of $11. The price of the stock is trading at $14.

The option is therefore, “in the money” and I.N. Vestor can exercise the option. This is because the option gives I.N. Vestor the right to buy the stock for $11. He can then

immediately sell the stock for $14, a gain of $3 per share.

An Option’s Intrinsic ValueAt the Money A situation where an option’s strike price is the same as the price of the underlying securityCurrent Stock Price = Strike PriceOut of the MoneyAn option that would be worthless if it expired today because the price of the underlying security is below the strike priceCurrent Stock Price < Strike Price

An Option’s Intrinsic Value Example:I.N. Vestor thinks the Chatpad, a new web developing company, is a good company and that the stock price will increase from its current trading price of $60 per share.I.N. Vestor has two options:

1. He can buy Chatpad stock for $60 right now.2. He can pay $10 to buy the option to buy Chatpad stock anytime

over the next month for the strike price of $70 per share. The option costs him $1,000 whereas purchasing 100 shares at $60 per share would be $6,000.

I.N. Vestor chooses to buy the option. Within the next month, Chatpad stock plummets to $30 per share. I.N. Vestor does not exercise the option because it is “out of the money”. He is happy he bought the option rather than the shares.

An Option’s Intrinsic ValueCall Option Put Option

In the Money Current Stock Price > Strike Price Current Stock Price < Strike Price

Out of the Money Current Stock Price < Strike Price Current Stock Price > Strike Price

At the Money Current Stock Price = Strike Price Current Stock Price = Strike Price

Interest Rate SwapsIn an interest rate swap, two market participants, known as counterparties, agree to exchange interest payments for a set period of time, typically from 1-5 years.

One counterparty makes a payment based on a fixed rate of interest, while the other counterparty makes a payment based on a floating rate of interest.

Credit Default Swaps (CDS)

Buyer of the swap receives credit protection and the seller of the swap guarantees the credit worthiness of the fixed income security

The risk of the default is transferred from the holder of the fixed income security to the seller of the swap

Swap that transfers the credit exposure of fixed income products between parties

BuyerSeller

Credit ProtectionRisk of defaultSwap

Credit Default Swaps (CDS) Example:

I.N. Vestor buys a $1,000,000 Frizzle,Inc. bond.I.N. Vestor wants protection against loss of principal in the event Frizzle, Inc. defaults on payment.I.N. Vestor buys a credit default swap contract from a third party.I.N. Vestor makes periodic payments to the third party and

in return has insurance on his debt instrument.If Frizzle, Inc. defaults, then the third party reimburses I.N. Vestor the face value of the Frizzle, Inc. bond ($1,000,000).

Credit Default Swaps (CDS)