© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Investing in Stocks and Bonds

#12

The Risks Of Investing

• Business• Financial• Market• Purchasing Power• Interest Rate• Liquidity• Event

Returns from Investing

• Current income bond interest, stock dividends, rent on real estate• Capital gains increase in market value• Interest-on-interest returns must be reinvested for compounding

Elements of Return 8%, 20 Year Bond

The Risk-Return Trade-Off

If you want greater return you will most likely have to accept greater risk

Amount of risk is directly related to expected return

The Risk-Return Relationship

What Makes A Good Investment?

Future return

Approximate yield

Desired rate of

return

Approximate Yield

whereCI = average annual current income FP = expected future price of investmentCP = current market price of investmentN = investment period

04/19/23

Investing in Common Stock

Each share represents equity or part ownership in the company

• Investor participates in firm’s profits

• Stock ownership is residual– firm’s obligations paid first

The Dow and the NASDAQ, 1999-mid 2009

• Common stockholders usually receive one vote per share

• Most small shareholders assign their votes to a proxy

• assign stockholder’s voting rights to another

Voting Rights

• Cash dividends and long-term capital gains are both taxed at maximum 15%

• 5% if in 10 and 15% tax bracket5

• Gains are not taxed until realized

Basic Tax Considerations

• Determined by firm’s board of directors

• Cash dividends usually paid quarterly

Can be paid even if

company shows a loss

Dividends

• Cash dividends - most common and most desirable

• Stock dividends - new shares given to current shareholders

Dividend Yield =Annual dividend per share

Market price per share

Dividends

04/19/23

Key Measures of Performance

Book Value - amount of stockholder’s equity in a firm

• Good when– book value steadily increases– market value exceeds book value

Book Value = Total assets – (liabilities + preferred stock)

04/19/23

Net Profit Margin - one of the most widely used measures of corporate performance

• Relates net profit to sales• The more money the company earns,

the higher the net profit • Stable or increasing net profit margins

are a good sign

Key Measures of Performance

04/19/23

Return on Equity – shows firm’s overall profitability from stockholders perspective

• Ratio of net income to common equity• Reflects company’s management of

assets, operations, and debt• Better ROE = better financial condition

and competitive position of firm

Key Measures of Performance

04/19/23

EPS =

Net profit after taxes – Preferred dividends paid

Number of shares outstanding

Earnings per Share (EPS) - amount of net income earned by a share of common stock

Key Measures of Performance

04/19/23

βeta – indicates stock’s price volatility relative to the market

• The market, as a performance benchmark, is assigned a βeta = 1

• If βeta < 1 then stock less volatile • If βeta > 1 then more volatile

Key Measures of Performance

04/19/23

Types of Common Stock

Blue-Chip - large, well established companies

• Usually pay dividends which lends price stability

• Returns are considered more dependable and less risky

04/19/23

Types of Common Stock

Growth above average growth rates in operations and earnings

• Usually low or no dividends

• May experience more price volatility

Tech companies in technology sector

• Mostly growth or speculative stocks– Some are

blue-chip stocks

04/19/23

Types of Common Stock

Income • fairly stable

earnings stream• pay high dividends• attractive to those

seeking current income

Speculative • high risk companies• company, products, or

industry may be new or unproven

• stock prices may be highly volatile

04/19/23

Types of Common Stock

Cyclical • stock prices move in

same direction as business cycle

• often found in basic industries

• have a positive βeta

Defensive• stock prices are

stable in economic downturns

• provide basic needs, consumer goods

• βetas are low or negative

04/19/23

Types of Common Stock

Mid-Cap

• market caps of $2-10 billion

• greater returns than larger firms and less volatile than small caps

Small-Caps • market caps

of $2 billion or less

• prices can be volatile due to high risk exposure

Large-Cap • market caps

over $10 billion

04/19/23

Foreign stock - issued by firms in other countries

• provide portfolio diversity• international mutual funds and American

Depositary Receipts (ADRs) are convenient ways to invest in foreign securities

• currency exchange rates can impact returns

Market Globalization and Foreign Stock

Investing in Common Stock

Advantages• Potential returns• Actively traded

and highly liquid• Involve no direct

management

Disadvantages• Risk• Timing of sales

and purchases• Uncertainty of

dividends

Making the Investment Decision

• Putting a value on stock

• Plow back earnings– Dividend reinvestment plan (DRP)

Cash or Reinvested Dividends

04/19/23

Investing in Bonds

• Fixed income security• Interest rates and bond prices

move in opposite directions• Versatile• Preservation and long-term

accumulation of capital• Lower risk and return than stock

04/19/23

Bonds v. Stocks

04/19/23

Bond Issue Characteristics

• Like a loan - bondholder lends money to issuer• Interest - usually paid every 6 months• Coupon - annual interest rate paid by issuer• Maturity date - when loan ends

– issuer repays principal to bondholder

04/19/23

• Par value – principal amount repaid at maturity– usually $1000 on a corporate bond

regardless of purchase price

• Selling before maturity may generate capital gains or losses

Discount bond = market price < parPremium bond = market price > par

Bond Issue Characteristics

Collateral• Senior or Secured Bonds - backed by a legal

claim on specific property – Liquidated to pay bondholders if issuer defaults

– Mortgage bonds, Equipment trust certificates • Junior or Unsecured Bonds - backed only by

issuer’s promise – Debentures

Bond Issue Characteristics

Sinking Fund • Annual

repayment schedule detailing used to pay off the issue

Call Feature• Bond provisions

must state if bond can be called prior to maturity– Freely callable– Noncallable– Deferred call

Bond Issue Characteristics

The Bond Market

• Treasury Bonds

• Agency and Mortgage-Backed Bonds

• Municipal Bonds

• Corporate Bonds

• Convertible Bonds

The Bond Market

U.S. Treasury long term debt pays semi-annual interest, sold via auctions

• Notes: 2, 3, 5, 10 year maturities

• Bonds: 20, 30 year maturities

The Bond Market

• Treasury Bonds – 20 or 30 year maturities• Treasury Notes – 2, 3, 5, 10 year maturities• TIPS – Treasury security with principal

payments adjusted for inflation

Note: Exempt from state and local taxes

The Bond Market

• Agency Bonds– Issued by subdivisions of the government

• Not obligations of US Treasury

– Yields above Treasuries

• Mortgage-backed Securities include Fannie Mae and Freddie Mac

The Bond Market

Municipal Bonds• Issued by state and local governments • Considered “tax-free bonds” since interest

usually free from federal income tax

The Bond Market

Municipal bonds

• Serial obligations – different maturities and coupon rates

• Revenue bonds – serviced from income generated by specific project

• General obligation bonds – backed by full faith and credit of issuer

The Bond Market

Corporate Bond segments• Industrials• Public utilities• Rail and transportation • Financial issues

The Bond Market

Convertible Bond - Debenture that may be converted into a certain number of company’s common stock

• Conversion privilege• Conversion ratio• Conversion value• Conversion premiums

04/19/23

Bond Ratings

Letter grade designates quality

the lower the rating

the greater the risk of default

the higher the coupon rate which must be offered

04/19/23

Bond Ratings

04/19/23

Bond Prices and Yields

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

Inverse relationship between price and interest rates

Premium bond > $1,000Discount bond < $1,000

04/19/23

Bond Prices

04/19/23

Bond Yields

• Yield is rate of return earned if bond is held the bond for stated time period

• Most common bond yields are– current yield – yield to maturity

• Amount of annual interest income the bond provides relative to current market price

Current Yield

04/19/23

Yield to Maturity (YTM)

• Annual rate of return if bond is held until maturity

• Measures– annual interest income – recovery of principal

04/19/23

Yield to Maturity (YTM)

If bond is purchased at face value YTM = coupon rate

If bond purchased at a discount YTM > coupon rate

If bond purchased at a premium YTM < coupon rate