© 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.
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