This Document Contains Chapters 11 to 12 Chapter 11 Investment Planning Chapter Outline Learning Goals I. The Objectives and Rewards of Investing A. How Do I Get Started? B. The Role of Investing in Personal Financial Planning 1. Coming Up With the Capital 2. An Investment Plan Provides Direction C. What Are Your Investment Objectives? 1. Current Income 2. Major Expenditures 3. Retirement 4. Shelter from Taxes D. Different Ways to Invest 1. Common Stock 2. Bonds 3. Preferreds and Convertibles 4. Mutual Funds, Exchange Traded Funds, and Exchange Traded Notes 5. Real Estate II. Securities Markets A. Primary and Secondary Markets 1. Primary Markets 2. Secondary Markets B. Broker Markets and Dealer Markets 1. Broker Markets 2. Dealer Markets C. Foreign Securities Markets D. Regulating the Securities Markets E. Bull Market or Bear? III. Making Transactions in the Securities Markets A. Stockbrokers 1. Selecting a Broker 2. Full-Service, Discount, and Online Brokers 3. Brokerage Fees 4. Investor Protection B. Executing Trades C. Types of Orders 1. Market Order 2. Limit Order 3. Stop-Loss Order IV. Becoming an Informed Investor A. Annual Stockholders' Reports B. The Financial Press 1. Market Data a. Dow Jones Industrial Averages b. Standard & Poor's Indexes c. The NYSE, NASDAQ, and Other Market Indexes 2. Industry Data 3. Stock Quotes C. Advisory Services V. Online Investing A. Online Investor Services 1. Investor Education 2. Investment Tools a. Investment Planning b. Investment Research and Screening c. Portfolio Tracking VI. Managing Your Investment Holdings A. Building a Portfolio of Securities 1. Investor Characteristics 2. Investor Objectives B. Asset Allocation and Portfolio Management C. Keeping Track of Your Investments Major Topics Investing is a key element of personal financial planning because it allows the individual to meet many of his or her long-term financial goals by saving and using the funds in such a way that an additional return is earned. Once the level of savings in nearly riskless assets reaches an amount that is sufficient for emergency and other short-term purposes, funds can be put into various forms of investments. To be a successful investor, you must understand the institutions, mechanisms, and procedures involved in making securities transactions. Without this knowledge it would be impossible for you to take advantage of the opportunities offered in the financial markets, which, in turn, can be of real help in achieving your personal financial goals. The major topics covered in this chapter include: 1. Investing is a long-term activity, while speculating is a short-term activity. 2. Investment objectives include current income, saving for major expenditures, retirement funds, and tax shelters. 3. There are many ways to invest, including stocks, bonds, convertibles, preferred stock, mutual funds, real estate, commodities, financial futures, and options. 4. Security markets include the organized exchanges and the over-the-counter market. 5. The services of a brokerage provide access to the organized markets. 6. A computer network of dealers provides access to unlisted securities in the overthe-counter market. 7. Transactions in securities are for cash or credit. 8. There are a variety of sources for investment information, ranging from stockholder reports to brokerage and advisory service reports and the financial press. 9. Daily information about the markets and their performance is available by observing various indexes and averages. 10. The Internet provides individual investors access to discount brokers as well as to investment services, information, and tools in order to better select and monitor their own portfolios. 11. Developing a well-diversified portfolio, based on sound asset allocation principles, is the key to improved returns and/or lower risk. Key Concepts A key to this chapter is the use of investing as a tool to achieve one's long-term financial goals. But to understand the application of investing to financial goals, it is necessary to understand the nature of the investments and the securities markets. The following phrases represent the key concepts stressed in this chapter. 1. Investing versus speculating 2. Investment objectives and plan 3. Primary and secondary markets 4. Organized securities exchanges and the over-the-counter market 5. Foreign securities markets 6. Regulation of the market 7. Bull and bear markets 8. Securities transactions through full service, discount, and Internet brokers 9. Orders to buy or sell 10. Margin trading and short selling 11. Sources of investment information 12. Online investment services, information and tools 13. The concept of diversification 14. Portfolio construction 15. Asset allocation and portfolio management 16. Prospectus 17. Bid price and ask price 18. Securities and Exchange Commission (SEC) 19. National Association of Securities Dealers (NASD) 20. Odd lot and round lot 21. Securities Investor Protection Corporation (SIPC) 22. Arbitration 23. Market order, limit order, and stop-loss (stop order) 24. Annual stockholders’ report 25. Dow Jones Industrial Average (DJIA) 26. Standards and Poor’s (S & P) indexes, NYSE index, and Dow Jones Wilshire 5000 Index Financial Planning Exercises The following are solutions to some of the problems at the end of the PFIN 4 textbook chapter. 1. The solutions to this problem appear on Worksheet 11.1 on the following pages. The keystrokes for using the financial calculator appear below (set on 1 payment per year and End Mode). a. b. c. 50,000 +/- FV 50,000 +/- FV 50,000 +/- FV 8 N 8 N 10,000 PV 10 I/YR 10 I/YR 8 N PV $23,325.37 PMT $4,372.20 10 I/YR PMT $2,497.76 d. An investment plan is a statement, preferably written, that sets out how capital will be invested to reach the financial goal. Once Beverly decides on a course of capital accumulation, she must choose an investment plan outlining how she will invest to earn the ten percent she requires. Once she decides on the best investment vehicles, she must stick to the plan in order to ensure success. Problem 1(b)—Worksheet 11.1 (No initial investment) Problem 1(c)—Worksheet 11.1 ($10,000 initial investment ) 2. The NYSE has the most stringent listing requirements of all the organized exchanges. There is a certain amount of prestige in being listed on the NYSE, because these companies have to have a certain minimum size market capitalization as well as meet certain profitability levels. If listed companies fall below these requirements, they stand to be delisted. However, even large, established companies that could easily meet these requirements may choose to stay on the NASDAQ instead. While the NYSE signals traditional standards, NASDAQ signals growth, vitality and innovation. According to NASDAQ's Web site, more companies now list on NASDAQ than all other major U.S. stock markets. It is the fastest growing major U.S. stock market and trades more shares per day than any other U.S. equities market. Many companies wish to tap into the energy generated by this environment. 4. WhenTyler places his market order to buy 100 shares of Google with his broker, the order is immediately transmitted to the main office of the brokerage firm and then to the exchange floor, where it is immediately executed. Confirmation that the order has been executed is transmitted back along the same route; from the floor of the exchange back to the broker placing the order and then to the customer. Due to the sophisticated telecommunications involved, the entire process may take only a matter of minutes. If Tyler instead places a limit order, the broker transmits the specified buy or sell price to an exchange specialist dealing in the given security. The specialist notes the limit order and limit price in his or her "book." The order is executed as soon as the specified market price is in effect and all other such orders with precedence have been satisfied. The order can be placed to remain in effect until a certain date or until canceled. Such an instruction is called a “good till canceled” order (GTC). 5. Student Answers will vary with market dates. This question requires that students look at the current levels of the various indices and also their performance during the last six months. Thus the current status of the markets – bullish or bearish – will be determined by the data period chosen. The answer to the whether the current market is bullish or bearish depends on the recent course of stock prices and investor sentiment. Bull markets are favorable markets normally associated with investor optimism, economic recovery, and governmental stimulus. Bear markets are unfavorable markets normally associated with investor pessimism, economic slowdowns, and government control. The markets are either bullish or bearish, depending upon whether stock prices are generally rising (a bull market) or falling (a bear market). Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 11-1. Investing is the vehicle through which we achieve many of our financial goals. In our personal financial plan we set financial goals such as buying a house or paying for our children's education. One way to accumulate funds to achieve these long-term goals is by investing. 11-2. A capital accumulation plan is the first step toward an investing plan. It is used to build a pool of funds for various needs, including savings for short-term needs and emergencies. Once this fund is sufficient for these purposes, the balance can be used to implement an investment plan, which is a strategy to invest funds to meet certain goals. 11-3 Investment objectives are important because they are so closely tied to overall personal financial planning and the achievement of financial goals. Clearly defining investment goals helps to develop appropriate strategies to reach them. 11-4. Both money and capital markets can be further divided into primary or secondary markets. The primary market is where a security is first issued to the investing public, and the issuing company receives the proceeds. For example, when a company comes out with a new issue of common stock, it does so in the primary market. In contrast, investors trade outstanding issues in the secondary market. The NYSE, AMEX, NASDAQ, and all the other exchanges are part of the network of secondary markets, and this is where the vast majority of securities transactions take place. The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are both national in scope, but the similarities end there. The NYSE dominates the AMEX in size, trading volume, etc., and the quality of the companies is much higher on the NYSE (the listing requirements on the NYSE are far more stringent than those on the AMEX). Over 3,000 firms with over 3,300 different stocks (including several hundred foreign issues) and about 1,600 corporate bonds are listed on the NYSE. The AMEX has only about 800 listed stocks and just a few listed bonds. The organized exchanges account for about half of the total dollar volume of all common shares traded in the U.S. stock market. 11-5. The broker market consists of national and regional “securities exchanges” while the dealer market is make up of both NASDAQ market and the OTC market. 11-6. There are several regional exchanges that deal primarily in securities with local and regional appeal. They typically list between 100 and 500 securities. Most are modeled after the NYSE, but their membership and listing requirements are considerably more lenient. They will often list securities that are also listed on the NYSE or AMEX in order to enhance their trading activity. The Midwest, Pacific, Philadelphia, Boston, and Cincinnati exchanges are the biggest and best known of the regional exchanges. 11-7. Rather than being a physical marketplace, such as the NYSE, the NASDAQ market is composed of hundreds of brokers and dealers linked together via a communications network which allows the buyers and sellers of securities to initiate trades. There are no real listing requirements in the NASDAQ market; all types of unlisted securities can be sold or traded in this market. 11-8. There are about 7,000 actively traded issues in the NASDAQ (National Association of Securities Dealers Automated Quotation System) portion of the OTC with about 2,700 of these being part of the National Market System (NMS). The NMS is for the largest, most actively traded securities, which generally have a national following. Trades for these securities are executed efficiently, and these stocks are about as liquid as those traded on the NYSE. However, the vast majority of the firms traded in the OTC market are not part of NASDAQ. These are very small firms which are “thinly traded”—not much of a market exists for them, and they are rather illiquid. These stocks are listed on the “pink sheets,” which are published daily and are available from brokers. The electronic quotes available at any given time on these companies may not be current, as prices are only updated electronically at the request of the traders or when there is significant trading. 11-9. Bull markets are favorable markets normally associated with investor optimism, economic recovery, and governmental stimulus. Bear markets are unfavorable markets normally associated with investor pessimism, economic slowdowns, and government control. The markets are either bullish or bearish, depending upon whether stock prices are generally rising (a bull market) or falling (a bear market). The answer to whether the current market is bullish or bearish depends on the recent course of stock prices and investor sentiment as the instructor conducts the course. An interesting discussion of the current market could include comments on such things as the age of the bull or bear market, signs that it will continue or change, who the current market participants seem to be, and any other information that could help describe the current and future course of the market. 11-10. The function of a discount broker is to make trades, purchases, and/or sales for his or her customers at a low cost. Because discount brokers usually provide little brokerage advice, their overhead is minimal, and this cost saving is passed along to the customer via reduced transactions costs. With the increase in the number of discount brokerage firms, there is greater variation in both fees charged and services offered. Some firms base commissions on the dollar value of the transaction, some on the number of shares, and some use both (refer to Exhibit 11.3). Those with higher commissions generally offer more services such as sweep accounts and research; some charge for research reports. 11-11. Online brokers allow investors to execute trades electronically online. Investors first establish an account with an online broker and then start trading by accessing the online broker’s Web site. Online services are appealing to people who are comfortable with using computers and are willing to research their selections themselves. An individual investor who usually trades in round lots and who does not need research and advisory help will usually find the services of the discount or online brokers most helpful. In contrast, if you normally deal in small/odd lots, the discounters are not for you—indeed, they sometimes discourage such business by charging sizable minimum fees. However, technology and services offered are changing rapidly, so it pays to check around for the latest offerings. 11-12. The SIPC (Securities Investor Protection Corp.) is a private, non-profit organization authorized by the U.S. Congress (in 1970) to protect customer accounts against the financial failure of a brokerage firm. SIPC insurance covers each account for up to $500,000, of which up to $100,000 may be in cash balances held by the firm. This insurance does not guarantee that the dollar value of the securities will be recovered. It only ensures that the securities themselves will be returned. The SIPC is not intended to insure against investment losses or bad advice from a broker. If you do lose money as a result of bad advice, the first thing to do is to discuss the situation with the managing officer at the branch where you do your business. If that does not work, write the firm's compliance officer and contact the securities office in your home state. If that still does not help, the claim might have to go into arbitration. 11-13. Arbitration and mediation are two methods of dispute resolution. With arbitration, the two parties—in this case, you and your broker—present the two sides of the argument before an arbitration panel, who then decides how the case will be resolved. If it is binding arbitration—and it well could be—you have no choice but to abide by the decision. As an alternative to arbitration, an investor may try to resolve the matter through mediation. The idea is to have the two parties try to negotiate with one another in order to settle their dispute and voluntarily arrive at a settlement. 11-14. The three basic types of orders are the market order, the limit order, and the stop-loss order. A market order is placed to buy or sell stock at the best price available at the time it is placed. A market order usually takes only seconds to fill once it hits the trading floor. A limit order is an order to buy at a specified price or lower, or to sell at a specified price or higher. The order is executed as soon as the specified market price or better exists and all other such orders having precedence have been satisfied. A limit order can remain in effect until a certain date or until canceled. With a limit order, the investor is looking for an attractive opportunity to trade. A stop-loss order is an order to sell a stock when the market price reaches or drops below a specified level. When the stop price is reached, the stop order then becomes a market order. With a stop-loss order, the investor is attempting to put a floor under his or her possible losses. However, the investor is not guaranteed that their stop-loss will be executed at the specified price. If the market starts to tumble and a stop-loss order kicks in, the next available price may be lower than the specified price. 11-15. Investors who use margin trading to purchase securities can magnify their returns on investments if stock prices rise because they have fewer of their own dollars at risk. However, margin trading also magnifies losses because in the event of a loss, investors are out not only their own dollars lost, but also the interest owed the broker. 11-16. A short sale is a transaction that involves selling borrowed securities in the expectation that they can be repurchased at some future date at a lower price. The short seller profits when the price of the security falls, making money by selling the securities at a higher price and then buying them back later at a lower price. The idea behind a short sale is just like any other transaction: buy low and sell high; the only difference is the short seller does it in reverse. The securities sold are borrowed on behalf of the short seller by his or her broker. The brokerage firm requires the short seller to abide by certain rules and regulations when making a short sale. 11-17. The four basic types of investment information that investors should try to follow are: 1. Economic developments and current events—to help you evaluate the underlying investment environment. 2. Alternative investment vehicles—so that you can stay abreast of market developments. 3. Current interest rates and price quotations—both to monitor your investments and to stay alert for developing investment opportunities. 4. Personal investment strategies—so that you can hone your skills and watch for new techniques as they develop. 11-18. Market averages and indexes describe the general behavior of the securities markets over time. These averages move up and down in accordance with price movements of the securities comprising the average or index. The averages or indexes most closely followed by the investing public are the Dow Jones Industrial Average, the Standard & Poor's 500 Index, the New York Stock Exchange Composite Index, and the American Stock Exchange Index. In addition to these, there are several other indexes—including the NASDAQ composite, the NASDAQ 100, Wilshire 5000, and MidCap 400—whose behavior is widely reported in the financial media. 11-19. The Dow Jones Industrial Average is the oldest and probably most widely followed measure of overall stock market performance and is composed of 30 blue-chip industrial companies. The S&P 500 Index is composed of 500 large companies. Because this index is based on more stocks and represents a wider variety of companies than the DJIA, it is also a very popular measure of overall stock market performance. The S&P MidCap 400 is composed of 400 medium-sized companies with market caps from about $ 1 billion to $4.4 billion, and is used to assess medium company stock performance. The NASDAQ Composite is often used to assess the price behavior of high tech stocks—because so many high tech stocks trade on the NASDAQ—and is calculated using virtually all the stocks traded on the NASDAQ system. The Russell 2000 Index tracks the behavior of 2,000 small-sized companies and is used as a broad measure of the small-cap segment of the market. The Wilshire 5000 Index is actually composed of 6,000–7,000 stocks and reflects the total market value of 98-99% of all publicly traded stocks in this country. It is used not only as a measure of the total market behavior but also of total market size on any given day. 11-20. The Internet has opened the world of investing to small, individual investors. Not only can individuals execute trades quickly and inexpensively through discount Internet brokers, but they can also easily and quickly access a wealth of information and screening tools once available only to professionals. 11-21. Individuals can obtain real-time quotes, monitor and chart their portfolios and trade many different types of securities in addition to stocks. 11-22. Online investment tools include financial calculators and worksheets, screening and charting tools, portfolio trackers, and personal calendars that notify you of forthcoming announcements and send you alerts concerning your stocks. These tools can be used to aid in developing financial plans and setting investment goals, finding securities to meet your objectives, analyzing potential investments, and organizing your portfolio. 11-23. Day traders are the opposite of the traditional buy-and-hold investor with the longterm approach. Day trading involves buying and selling stocks quickly throughout the day. Day traders attempt to make quick profits by buying in and then selling while the stock is still on an upward trend. Some day traders also do short sells in anticipation of price decreases. True day traders do not own any stocks overnight for fear that prices might change radically in the wrong direction overnight. 11-24. Placing "all your eggs in one basket" may prove to be extremely rewarding, but it also introduces the risk that you could suffer a significant loss or even lose your total investment. By investing in a portfolio rather than a single security, you can spread risk over a number of securities rather than a single issue. The overall return will also vary, because at any given time some securities will have a higher yield than will others. A portfolio provides diversification, protection, more security, and probably a more favorable risk-return tradeoff for the investor. 11-25. Asset allocation involves a decision on how to divide your portfolio among different types of securities in order to diversity your holdings and thereby lessen your overall exposure to risk. You determine what asset mix best meets your financial goals, and once the mix is set, you select the specific securities for each asset category. For example, a portfolio's asset mix could be 20% in short-term securities (money market), 20% in bonds, and 60% in stocks. 11-26. Once you establish your portfolio according to the asset allocation scheme, these percentages guide you in investing new money and also in rebalancing your portfolio if the value of an asset class changes significantly. 11-27. Keeping track of your investment holdings is essential to a well-managed securities portfolio. Just as you need investment objectives to provide direction to your portfolio, keeping track of your holdings helps you monitor it. An informed investor knows what his or her investment holdings are, how they have performed over time, and whether or not they have lived up to expectations. If they have not performed as expected, you may want to sell them so that you can put your money into securities that better suit your investment objectives. In addition, by tracking your portfolio you keep good records for tax purposes. Solutions to Online Bonus Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. a. Price of stock at time of quote was $44.56 at 1:34pm EDT on August 1, 2012. b. The price earnings ratio was 20.44; this is the current market price per share divided by the per share earnings for the most recent 12-month period (from the company’s income statement). Therefore, the stock shows a nice solid multiple. In other words, this means that investors are willing to pay more than $20 for every $1 of earnings per share that the company generated last year. c. The last price at which the stock traded on the previous trading date was the closing price of $44.17. d. The stock’s dividend yield was 3.80%. e. The highest price at which the stock traded during the past 52-week period was $45.17 and the lowest price for the same period was $29.47. f. The market capitalization for the firm is $135.74 billion. Market capitalization is the total market value of all shares of the company’s stock that is traded. 2. This exercise serves to illustrate that a company's stock price per share by itself does not indicate how much a company is worth. Two companies with the same total valuation can have stock prices that are very different, depending on the number of shares each company has outstanding. Some companies like to split their shares when their stock price climbs to a certain level in order to make their shares more affordable to a larger number of investors. Others, like Berkshire Hathaway, do not. The following table presents and example of how students should set up their data for comparison purposes. Total value and price per share will vary depending on the date of the quotes. Therefore, it is suggested that the instructor choose the date for standardization of grading and conclusions explained by students. BRKA JPM HD AAPL WMT VZ Price/Shar e No. Shares 50 150 100 100 150 50 Total Value 3. If Harmony Shadwell buys 300 shares of Google at $757.49 a share, the total transaction will cost $227,247. If she uses the maximum margin available from her broker, she will borrow 50% of the purchase price, or $113,623.50. Harmony must supply the other 50% of the purchase price, or $113,623.50 from her own funds. Also note, she will have to pay interest on the funds borrowed (for the illustration below, we used 4% interest). If Harmony bought the stock at $757.49 per share and sold it at $800, she would make a total profit on each share of $42.51 or of $12,753 in total. To illustrate the effect of margin on stock returns, consider the following: Without Margin With 50% Margin Total Profit $12,753 $12,753 Less Interest − 0 − 4,545 Net Profit $12,753 $8,208 Amount of Own Capital Invested $227,247 $113,623.50 Return on Investment 5.61% ($12,753/$227,247) ($8,208/$113,623.50) 7.22% Thus, while the dollar amount of the Net Profit may be more without the margin (because there is no interest to pay), the percentage return on investment is higher with the margin trade (because less of the investor’s capital is involved). Keep in mind that these results can change depending upon the interest rate charged. 4. [Note: The percentage return will be the same whether one share is owned or $5000 worth is owned. Therefore, to simplify calculations, returns will be determined for one share.] The general equation for determining the return is: Return = Price Appreciation Original Investment a. $90 − $60 = $30 = 50% $60 $60 b. $30 − $20 = $ 10 = 100% ($20 × .5) $10 c. $55 − $40 = $15 = 50% ($40 × .75) $30 Alternative (b) offers the best return on the investment while alternatives (a and c) offer the lowest returns. 5. Refer to the completed Worksheet 11.2 on the following page. It is suggested that the instructor provide the students with a specific day on which to complete the worksheet so that the numbers can be easily compared. Students should also check for stock splits, or stocks will appear to have a loss when in fact they have a profit. 6. If Clay Sorensen sold 300 shares of stock short at $100 per share and the price of the stock dropped to $70 per share, he would make a profit of $30 per share ($100 − $70) or $9,000 ($30 × 300 shares), ignoring commission costs. That is, he is selling a stock at $100 a share which he is later going to buy at $70. His profit is the difference between what he paid for the stock ($70) and what he sold it for ($100), or $30 per share. 7. a. If Aaron sold the stock short at $40 per share and repurchased at $50 per share, he had a loss of $10 per share. Multiply his loss of $10 per share times 100 shares for a total loss of $1,000. b. If Aaron bought the stock at $40 per share and later sold it at $50 per share, he had a gain of $10 per share. Multiply his gain of $10 per share times 100 shares for a total gain of $1,000. c. If Aaron sold the stock short at $40 per share and later repurchased it at $25 per share, he had a gain of $15 per share. Multiply his gain of $15 per share times 100 shares for a total gain of $1,500. 8. a. Investors who sell a stock short must deposit with the broker an amount of money equivalent to the prevailing initial margin requirement, in this case 50%. If she shorted 500 shares of a stock currently selling at $75 per share, she had to have on deposit with the broker $75 × 500 × .50 = $18,750. b. If the investor shorted the shares at $75 and repurchased them at $55, she made a profit of $20 per share. Multiply 500 shares × $20 per share for a total gain of $10,000. c. The investor made a gain of $10,000 and had at risk $18,750 of her own money to give her a return on her invested capital of 53.3% ($10,000 ÷ $18,750 = .533 = 53.3%). Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 11.1 The Uselton’s Struggle With Two Investment Goals 1. According to the worksheet which follows, the Useltons would need $53,282.97 to fund the educational needs of their children. This assumes they will need $40,000 in six years (which will require an investment of $28,188.87 today) and another $40,000 two years later, in eight years (which will require an investment of $25,094.10). Given they have already accumulated $45,000 for their kids' education fund, they are about $8,282.97 short of the amount needed. $28,188.87 Note 1: The “targeted financial goal” is the amount of money you want to accumulate by some target date in the future. 2. Using the financial calculator set on 1 P/YR and End Mode, these investments would be worth a total of $224,499.48 in 20 years, given an 6% investment rate. Mutual Fund: Retirement Account: 50,000 +/- PV 20,000 +/- PV 6 I/YR 6 I/YR 20 N 20 N FV $160,356.77 FV $64,142.71 3. The Useltons currently have $70,000 in their retirement nest egg. If they were to add $6,000 to their nest egg at the end of each of the next 20 years, they would have a total of $445,213.03. Using the financial calculator set on 1 P/YR and End Mode: 70,000 +/- PV 6,000 +/- PMT 6 I/YR 20 N FV $445,213 4. They are doing a great job in meeting both of their investment goals. Not only have they trying to meet the educational funding needs of their children, but they are well on their way to building up a retirement nest of almost half a million dollars. Keep up the good work! 11.2 Col BernardTakes Stock of His Securities 1. Refer to the completed Worksheet 11.2 shown on the following page. It is suggested that the instructor provide the students with a specific day on which to complete the worksheet so that the numbers can be easily compared; also, he or she might want to warn the students to check for any stock splits. A good site to research securities is finance.yahoo.com. When you pull up the stock's chart, the splits are marked and the dates written at the bottom. Also, you can pull up information about all the companies at once by typing in the tickers separated by a space. 2. The students will comment on whether or not Col's net worth has increased or decreased. They should also comment on whether or not his portfolio needs to be rebalanced. 3. Here, students can make a table like that presented below to show the percentage of his total portfolio represented by each company. Company Current Value of Stock % of Total Portfolio eBay $ % Watson Pharmaceuticals $ % United Technologies Corp. $ % JPMorgan Chase $ % Pepsico $ % Money Mkt. fund $ 12,000.00 % Totals $ 100.0% Chapter 12 Investing in Stocks and Bonds Chapter Outline Learning Goals I. The Risks and Rewards of Investing A. The Risks of Investing 1. Business Risk 2. Financial Risk 3. Market Risk 4. Purchasing Power Risk 5. Interest Rate Risk 6. Liquidity Risk 7. Event Risk B. The Returns from Investing 1. Current Income 2. Capital Gains 3. Earning Interest on Interest: Another Source of Return C. The Risk-Return Trade-off D. What Makes a Good Investment? 1. Future Return 2. Approximate Yield II. Investing in Common Stock A. Common Stocks as a Form of Investing 1. Issuers of Common Stock 2. Voting Rights 3. Basic Tax Considerations B. Dividends C. Some Key Measures of Performance 1. Book Value 2. Net Profit Margin 3. Return on Equity 4. Earnings per Share 5. Price/Earnings Ratio 6. Beta D. Types of Common Stock 1. Blue-Chip Stocks 2. Growth Stocks 3. Tech Stocks 4. Income Stocks versus Speculative Stocks 5. Cyclical Stocks or Defensive Stocks 6. Large-Caps, Mid-Caps, and Small-Caps E. Market Globalization and Foreign Stocks F. Investing in Common Stock 1. Advantages and Disadvantages of Stock Ownership G. Making the Investment Decision 1. Putting a Value on Stock 2. Timing Your Investments 3. Be Sure to Plow Back Your Earnings III. Investing in Bonds A. Why Invest in Bonds? B. Bonds versus Stocks C. Basic Issue Characteristics 1. Types of Issues 2. Sinking Fund 3. Call Feature D. The Bond Market 1. Treasury Bonds 2. Agency and Mortgage-Backed Bonds 3. Municipal Bonds 4. Corporate Bonds 5. Convertible Bonds E. Bond Ratings F. Pricing a Bond 1. Bond Prices and Accrued Interest G. Bond Prices and Yields 1. Current Yield and Yield to Maturity Major Topics The financial rewards from investing can be great. However, investors first need to understand the features of the various types of investments and the risks inherent in each. The major topics in this chapter include: 1. The risks associated with investing include business risk, financial risk, market risk, interest rate risk, purchasing power risk, liquidity risk and event risk. 2. Interest-on-interest underlies all elements of total return and is the basic assumption in estimations of future return. 3. The risk-return trade-off is an important element of investing. 4. Common stock is a rewarding type of investment security. 5. The valuation of common stock provides a means of specifying the risks and rewards associated with common stock investing. 6. Bond investing provides current income from interest. Key Concepts In studying investments, one must understand the jargon of the investment world. This chapter explains basic investment terminology and explores the features of the various types of investments. Key concepts in this chapter include the following: 1. The risks of investing – Business, Financial, Market, Purchasing Power, Interest Rate, Liquidity and Event Risks 2. Fixed income securities 3. Investment returns 4. Interest-on-interest 5. The risk-return trade-off, risk-free rate of return, and desired rate of return 6. Residual owners 7. Measures of return 8. Common stocks 9. Rights of common stockholders 10. Proxy 11. Dividends 12. Dividend yield 13. Stock dividends 14. Measures of stock performance 15. Common stock valuation 16. Types of common stock 17. Book value 18. Net profit margin 19. Return on equity (ROE) 20. Earnings per share (EPS) 21. Price/earnings ratio (P/E) 22. Beta 23. Blue-chip stock 24. Growth stock 25. Tech stock 26. Income stock 27. Speculative stock 28. Cyclical stock 29. Defensive stock 30. Large-cap stock 31. Mid-cap stock 32. Small-cap stock 33. Foreign securities and ADRs (American Depository Receipts) 34. Dividend Reinvestment plan (DRP) 35. Bonds 36. Bond issue characteristics – Premium and discount bonds 37. Types of bonds 38. Bond ratings 39. Bond prices and yields – current yield and yield to maturity 40. Inverse relationship between interest rates and bond prices 41. Zero coupon bonds 42. Mortgage bond and mortgage-backed securities 43. Equipment trust certificate 44. Debenture 45. Sinking Fund 46. Convertible bonds, conversion privilege, conversion ratio, conversion value, conversion premium 47. Call feature 48. Treasury bond 49. Treasury inflation-indexed bond (TIPS) 50. Agency Bond 51. Municipal Bond 52. Serial obligation 53. Revenue bond 54. General obligation bond 55. Corporate bond 56. Junk bond Financial Planning Exercises The following are solutions to problems at the end of the PFIN 4 chapter. 1. A good investment is one that promises enough return to compensate the investor for the amount of risk involved; this basic risk-return rule applies to any type of investment vehicle. Investments should also be selected according to their appropriateness for the investor's objective (for example, current income or long-term growth), time horizon, and liquidity needs. Tax implications can also influence investment choices, particularly for investors in the higher tax brackets. ($60 – $30) a. Approximate Yield = $2 + 3 = $12 = .2667 or 27% ($60 +$30) $45 2 ($100 – $40) b. Approximate Yield = $0 + 2 = $30 = .4286 or 43% ($100 + $40) $70 2 ($1000 – $1000) c. Approximate Yield = $50 + 1 = $50 = .05 or 5% ($1000 + $1000) $1000 2 Based on the above calculations, the investments would be ranked from highest to lowest expected return as b, a, then c; this assumes, of course, that there is equal risk exposure and identical tax implications in all three investments. 2. $115 – $75 $4 + 3 Expected Return = $115 + $75 2 = $17.33 = 18.2% $95 Using the financial calculator set on 1 P/YR and End Mode: 75 +/- PV 4 PMT 3 N 115 FV I 18.8% 3. Toby should not buy Great American Landscaping Inc. if he desires a 15% rate of return, as this stock's expected return will not be that high. $125 – $85 $0 + 4 Expected Return = $125 + $85 2 = $10 = 9.5% $105 Using the financial calculator set on 1 P/YR and End Mode: 85 +/- PV 0 PMT 4 N 125 FV I 10.1% 4. a. Earnings Per Share = Net Profit After Tax – Total Annual Preferred Dividends Number of Shares of Common Stock Outstanding = $15,800,000 – $1,000,000 = $14,800,000 2,500,000 2,500,000 = $5.92 b. Price/Earnings Ratio = Current Market Price of Common Stock Earnings Per Share = $60 = 10.14 times $5.92 c. Dividend Yield = Annual Dividends Received Market Price of the Stock = $1.75 = .029 or 2.9% $60 6. a. The current yield is found by dividing the annual interest income by the market price of the bond. It is basically the same figure as the dividend yield on a stock, and it would be important to investors seeking current income. b. The yield to maturity is the annual rate of return a bondholder would receive if he or she held the bond to its maturity. This yield is approximated by adding the annual income to the average capital gain over the life of the bond and dividing this by the average amount invested in the bond. Thus, whereas current yield involves only interest income, yield to maturity considers both interest income and capital gains. These yield measures are important to bondholders because they are used to assess the underlying attractiveness of a bond investment. If a bond provided a yield to maturity that equaled or exceeded the desired return on a bond, it would be an attractive investment. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. Quote Current Yield Yield to Maturity Using Financial Calculator 9%, 20 yr., $850 $90/$850 = 10.6% 850 +/- PV 1000 FV 90/2 PMT 20 x 2 N CPT I/YR 5.426 x 2 = 10.85% Yield to maturity using formula: ($1,000 – $850) Approximate Yield to Maturity = $90 + 20 ($1,000 + $850) 2 = $ 97.50 $925.00 = .1054 or 10.54% 9. Calculations for the two bonds follow. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. Yield to Maturity Quote Current Yield Using Financial Calculator a. 6.55%, 22 yr., 52.00 65.5/520 = 12.60% 520.00 +/- PV 1000 FV 65.50/2 PMT 22 x 2 N CPT I/YR 6.68 x 2 = 13.36% b. 10.25%, 27 yr., 103.625 102.50/1036.25 = 9.89% 1036.25 +/- PV 1000 FV 102.50/2 PMT 27 x 2 N CPT I/YR 4.93 x 2 = 9.86% Yield to maturity using formula: Bond a: ($1,000 – $520) Approx. YTM = $65.50 + 22 = $87.32 = 11.49% ($1,000 + $520) $760 Bond b: 2 ($1,000 – $1,036.25) Approx. YTM = $102.50 + 15 = $101.16 = 9.94% ($1,000 + $1,036.25) $1,018.13 2 Bond (a) has a higher current yield and yield to maturity than Bond (b). Answers to Concept Check Questions The following are solutions to “Concept Check Questions” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find the questions on the instructor site as well. 12-1 Investors are exposed to business risk, the possibility that the firm will fail, due to factors affecting the firm, such as economic or industry factors or poor management decisions. Business risk may be thought of as the degree of uncertainty associated with the firm's earnings and consequent ability to pay dividends and interest. There is financial risk, which is the risk associated with the mix of debt and equity financing used by the issuing company. Too much debt could also lead to financial failure. Market risk is reflected in the price volatility of a security and is associated with factors such as changes in political, economic, and social conditions and in investor tastes and preferences. Purchasing power risk is the risk resulting from possible changes in price levels that can have a significant effect on investment returns. In times of rising prices, the purchasing power of the dollar declines. Interest rate risk results from changing market interest rates that mainly affect fixed-income securities. The prices of these securities decrease with rising interest rates and increase with falling rates. Liquidity risk is associated with the inability to liquidate an investment conveniently and at a reasonable price. Finally, there is event risk, which is the risk that something totally unexpected will happen (like a corporate takeover) to cause the market price of a security to drop dramatically. 12-2. The risk-return trade-off refers to the universal rule of investing that the amount of risk associated with an investment is directly related to the expected return of the investment. If you want a higher return, you must be willing and able to accept a higher level of risk. The risk-free rate of return is the positive level of return that you can earn even though there is virtually no risk of default involved in the security. This rate is usually identified as the return on short-term government securities, such as Treasury bills. (Even though this is referred to as the “risk-free” rate, bear in mind that these low rates of safe return are very susceptible to purchasing power risk—the risk that the growth in the value of the investment will not keep pace with inflation. In addition, if these investments are held outside a tax-sheltered environment, they are also subject to taxes.) 12-3. The two basic sources of return are current income and capital gains. Current income is the amount of return generated annually from an investment and takes the form of dividends, interest, or rent. A capital gain, in contrast, reflects the price behavior of an investment over time and is captured through capital appreciation (or loss). 12-4. Interest-on-interest is one of the most important, yet most overlooked, sources of return. Interest-on-interest means keeping your capital fully invested—it means reinvesting the current income and realized capital gains into other investment products. It is through interest-on-interest that we are able to earn fully compounded rates of return (over the long haul) on our investments. Indeed, over extended (lengthy) periods of time, intereston-interest may account for as much as 40–60% of total return. 12-5. An investor's desired rate of return is the minimum rate of return acceptable for the amount of risk that the investor must bear. An investment should be considered acceptable only if it is expected to generate a rate of return that meets or exceeds the investor's desired rate of return. 12-6. Yes, tax-wise, it makes a difference to investors whether they receive a return on stocks in the form of dividends or capital gains. Short-term capital gains (gains on property held less than one year) are taxed as regular income to the taxpayer at rates which currently go up to over 30% (rates are scheduled to go down through time). Dividends and capital gains on property held longer than one year are taxed more favorably. For taxpayers in the 10% and 15% tax brackets, the rate is 5%. For taxpayers in brackets higher than 15%, the rate is 15%. Also, an even more favorable 5-year capital gains rate has recently come into effect. 12-7. Dividends can take two forms—cash dividends and stock dividends. Cash dividends are just what the name implies. The most common form of dividend, they are typically paid on a quarterly basis in cash. Stock dividends pay existing shareholders in new shares of stock. However, the shareholder's proportion of ownership and investment value remain the same. The price generally falls in direct proportion to the size of the stock dividend. Investors should prefer to receive cash dividends. Cash dividends provide additional return, while stock dividends do not represent additional value. When a company issues a stock dividend, the price of its shares falls accordingly, and each shareholder holds the same proportion of the company's total outstanding stock as before. 12-8. a. Book value represents the accounting value of a firm. The book value is determined by subtracting the firm's liabilities and preferred stock value from its assets. The resulting amount would be the book value of the common stock. b. Return on Equity (ROE) relates the amount of profits that the firm is generating relative to the firm's equity base, and it reflects the overall profitability of the firm. It captures the amount of success the firm is having in managing its assets, operations, and capital structure; ROE is important because of its impact on the profits, growth, and dividends of the firm. An increasing ROE is desirable, while a decreasing ROE is something the firm would probably rather avoid. c. Earnings per share (EPS) is the amount earned for each common share outstanding during a specific period of time. The EPS is determined by dividing all earnings after taxes and claims by preferred shareholders by the number of common shares outstanding. d. The price/earnings ratio (P/E) is calculated by dividing the price of the common stock by the earnings per share; it indicates how aggressively the stock is being priced relative to its earnings and reflects the level of investor confidence and expectations. e. Beta measures the market risk in a share of common stock; it reveals how the price of a stock behaves relative to the market (which has a beta of one). The larger the stock's beta, the more risky the investment. A stock with a beta of 1.7, for example, is considered to be more price volatile than one with a beta of 0.7. 12-9. Blue chip stocks are issued by the strongest, most stable companies and usually provide uninterrupted streams of dividends and strong long-term growth prospects. Growth stocks are expected to continue to experience consistently high rates of growth in operations and earnings. Both blue-chips and growth stocks have great appeal to investors with long-term investment objectives. Growth stocks offer better return at somewhat greater risk. Tech stocks are those of companies in the technology sector of the market. The technology sector has been a dominant sector in market growth during the past 10-15 years and is expected to remain fairly strong for the foreseeable future. Tech stocks usually fall into the growth or speculative category, although some are now in the bluechip category. Income stocks are purchased primarily for the high current dividends they pay. An added feature of these stocks is that the amount of their dividends usually increases over time. They are attractive to investors who need current income and are less concerned about future growth in value or the higher taxation of dividends. Speculative stocks offer the investor an unusual opportunity for price appreciation based on some special situation that has occurred in the company. These securities are usually not attractive to conservative long-term investors. Stocks whose price movements follow the economy are cyclical stocks. They tend to have positive market risk and are best used by investors when the economy starts to recover from a recession. Defensive stocks are considered counter cyclical since they usually do not move with the economy. These are generally lower risk stocks. Both cyclical and defensive stocks can be used in a portfolio that contains other types of stocks. Their purpose would be to change the risk of the portfolio. Mid-cap and small-cap stocks are stocks of companies whose market capitalization falls under certain limits: about $4–5 billion for mid-caps and $1 billion for small caps. Midcaps offer investors opportunities for capital appreciation and are an alternative to large stocks. Small caps, and even smaller micro caps, are riskier investments and require careful analysis. Student preferences among these stock types will vary, but point out that a diversified portfolio may well have some of each to provide long-term stability. 12-10. Research shows that most investors are better off investing steadily than trying to time the market. Because it is exceedingly difficult to buy consistently at market bottoms and sell at market tops, there is a high potential cost of being out of the equity market during its best-performing times. This is because pulling money out of the market exposes you to the significant risk that you’ll miss the months of good returns that could help you recoup prior losses. As the text indicated, ten good days out of the market could result in almost half the growth obtained by staying in the market. 12-11. In a dividend reinvestment plan shareholders can sign up to have their cash dividends automatically used to buy additional shares of the company's common stock. A major purpose of an investment program is to earn a fully compounded rate of return. This means keeping your money fully invested at all times, something that a dividend reinvestment plan allows you to do automatically. 12.12. Student answers will vary depending upon the assumptions entered 12-13. A secured bond is one that is backed by a legal claim on some specific property of the issuer, which is called collateral. These are senior bonds. Examples of secured bonds are mortgages, which are secured by real property, and equipment trust certificates, which are backed by equipment and are used by airlines and railroads. Unsecured bonds, although they are still legally binding debt obligations of the company, are not backed by property. They are backed only by the promise of the issuer to pay interest and principal on a timely basis. These are junior bonds, and debentures are probably the most popular of such issues. 12-14 No, junk and zero-coupon bonds are not the same. Junk bonds pay a high coupon and offer a high yield because they are considered to be a riskier investment. They are issued by companies which have received below-investment grade ratings on their bond issues. On the other hand, zero coupon bonds do not pay a coupon. They are sold at a deep discount to par value and mature at par value. Some zero-coupon bonds are very high quality and are particularly useful for investors who have a cash flow need at a certain target date. With no interest payments, investors do not have to worry about rates of return on reinvested interest payments. However, because there are no coupon payments, zeros experience greater price volatility when interest rates change, which can be of great concern to investors who sell zeros before maturity. Additionally, interest is “imputed” on zeros, and if they are held outside a tax-sheltered environment, investors must pay yearly income taxes on this imputed interest even though they have received no cash interest payments. . Municipal bonds are issued by state and local governments and provide interest income to investors that is not subject to federal income tax (Note: while the interest income is tax exempt, capital gains are not). The 1986 Tax Reform Act changed the tax status of some municipal bonds. If the proceeds of the bond issue are used for nonessential purposes, the interest received is subject to federal income tax. Additionally, if you live in a state with a state income tax and buy municipal bonds from another state, that interest income will be subject to your state’s income tax. And finally, taxpayers subject to the alternative minimum tax may have to pay federal income taxes on income from municipal bonds, so yes, taxes may have to be paid on municipal bonds. 12-15. A convertible bond is a type of debenture bond that carries with it the provision that within a certain time period it may be exchanged into a certain number of shares of the issuing company's common stock. Investors buy convertible bonds because they offer the steady income of a debt security plus the promise of participation in the growth of the equity value of the company should the price of the company's stock appreciate above the conversion price of the bond. 12-16. The conversion privilege stipulates the nature of the conversion feature. It includes a statement about the conversion period during which the bond can be converted, and the conversion ratio, which specifies the number of shares of common stock into which the bond can be converted. It is the conversion ratio acting with the market price of the common stock that gives the bond its conversion value. The conversion value is the value at which the bond would trade if it were priced to sell on the basis of its stock value. It is found by multiplying the conversion ratio, or the number of shares of common stock one will get, by the market price of the common stock. Since the conversion ratio is usually fixed, the conversion value can only change if and when the market price of the common stock changes. Therefore, a rise in the market price of the convertible will depend on a rise in the market value of the common stock. 12-17. Moody's and Standard & Poor's each have their own system of rating bonds. Their ratings reflect the quality and degree of risk they perceive in the bond. (See Exhibit 12.7 in the text for the ratings and associated interpretations.) Every time a large, new issue comes to the market, it is analyzed by a staff of professional bond analysts to determine its default risk exposure and its investment quality. The rating given applies only to that particular bond issue, so that one company could have more than one issue of bonds outstanding, and each could have a different rating. The rating agencies also reexamine older bonds to see if their ratings need to be changed. 12-18. In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction between clean prices and dirty (full) prices. This can be concisely summarized as: Dirty (full) price = quoted price + accrued interest Clean price = quoted price Dirty (full) price = quoted price + accrued interest Clean price = quoted price (a) The clean price would be: 951.25 (b) The dirty price would be: 951.25 + [(50/2) x (2/6)] = $959.58 So what's the significance of the distinction between dirty and clean prices for bond buyers? It's important to realize that the commonly-cited prices in the financial press and on the Web are most likely net of accrued interest and are so-called clean bond prices. The relevant sale or invoice price of a bond to the buyer is the dirty price, which adds the accrued interest to the quoted price. In terms of this problem, the buyer of the bond would pay the dirty price. In summary, the quoted clean price understates the true (dirty) price that must be paid to actually purchase the bond in the open market. 12-19. The higher the current market interest rate is relative to the stated interest rate on an outstanding bond, the lower the market price of the bond; in contrast, the lower the current market interest rate is relative to the bond's stated interest rate, the higher the market price of the bond. The current market interest rate viewed relative to the stated interest rate on a bond impacts the bond price in the marketplace. When the current market rate is higher than the stated rate, the bond sells at a discount. When the current market rate is below the stated (coupon) rate, the bond will sell at a premium. Current market rates, therefore, can have a profound effect on the prices of outstanding bonds. Solutions to Online Bonus Financial Planning Exercises The following are solutions to “Bonus Personal Financial Planning Exercises” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 1. a. Dividend Yield = Annual Dividends Received = $ 2.50 = .05 or 5% Market Price of the Stock $50.00 b. Book Value Per Share = Total Assets – Total Liabilities – Total Preferred Stock Number of Shares of Common Stock Outstanding = $20,000,000 – $8,000,000 – $3,000,000 500,000 = $18.00 per share c. Earnings Per Share = Net Profit After Tax – Total Annual Preferred Dividends Number of Shares of Common Stock Outstanding = $2,500,000 – $240,000 = $2,260,000 500,000 500,000 = $4.52 d. Price/Earnings Ratio = Current Market Price of Common Stock Earnings Per Share = $50.00 = 11.06 or 11 times $ 4.52 2. a. While student answers will vary, given the parameters in the question (capital appreciation and above-average risk tolerance), most will probably focus on the following categories: Growth and Tech stocks: These stocks are expected to achieve high growth rates and are ideal for this portfolio because of their potential for large gains from price appreciation. Growth and tech stocks typically carry betas over 1.0, which is not a problem for a risktaking investor. Speculative stocks: These would appeal to this investor as well. Unlike stocks with a proven record of earnings, these stocks are bought with the hope that prices will rise due to something new—products, information, research developments, etc. For example, stocks of biotech companies whose researchers are developing new treatments for cancer are speculative. Once they have a proven product, they may be considered growth stocks. Mid-cap stocks: Stocks with market capitalization under about $4–5 billion offer attractive return potential without the price fluctuations of speculative stocks. They would be a good balance to the riskier investments in the portfolio. Small-cap stocks: These stocks of companies with less than $1 billion in market capitalization offer high growth and return potential but with higher risk than midcaps. Point out that even a long-term growth portfolio should probably also contain some large blue-chip stocks, income stocks, bonds, and money market. Student answers will vary regarding their three stock selections and rationale. b. With a smaller amount to invest, students should include the more conservative categories—blue chip, defensive, income stocks, bonds and money market—in a greater proportion to provide a balance for higher risk holdings. A more risk averse investor might eliminate speculative stocks altogether and increase the amount of conservative securities. 3. Research shows that most investors are better off investing steadily than trying to time the market. Because it is exceedingly difficult to buy consistently at market bottoms and sell at market tops, there is a high potential cost of being out of the equity market during its best-performing times. This is because pulling money out of the market exposes you to the significant risk that you’ll miss the months of good returns that could help you recoup prior losses. As the text indicated, ten good days out of the market could result in almost half the growth obtained by staying in the market. 4. Book Value = Total Assets – Total Liabilities – Total Preferred Stock = $2,500,000 – $1,800,000 – $200,000 = $500,000 Book Value Per Share = Total Assets – Total Liabilities – Total Preferred Stock Number of Shares of Common Stock Outstanding = $2,500,000 – $1,800,000 – $200,000 50,000 = $10.00 per share Solutions to Critical Thinking Cases The following are solutions to “Critical Thinking Cases” found on the student website, CourseMate for PFIN 4, at www.cengagebrain.com. You can find these questions on the instructor site as well. 12.1 The Ashcrofts’ Problem: What to Do with All That Money? 1. The Ashcrofts have a comfortable income, no children, and no special goal for this money. They should take a long-term investment approach and can afford to be fairly aggressive in their choice of investments, depending on their tolerance for risk. 2. In selecting stocks for their portfolio, the Ashcrofts would want a fair amount of bluechip stocks with also some growth and defensive stocks to round out their holdings. Many blue-chip companies pay dividends, so some amount of income stocks would be included already in their blue chips. Their selection of growth stocks will probably include some tech stocks, and they can choose several from the mid-cap and small-cap range in order to balance out their portfolio. Defensive stocks provide some amount of downside protection in the event of an economic downturn. If the economic outlook is positive, the Ashcrofts also might want to include some cyclical stocks in their portfolio. The Ashcrofts do not need current income from their investments because they each earn a good living. Because they are probably in a fairly high tax bracket, any interest income and short-term capital gains from their investments would be taxed at their ordinary tax rate. Clearly, they would be better off with long-term capital gains and dividends which are currently taxed at a maximum rate of 15%, and capital gains are taxed only when the gains are realized. However, some amount of income producing securities, which could include bonds, should be included in a well balance portfolio because such investments tend to lower the overall risk of the portfolio and lend some amount of stability to price fluctuations. 3, The Ashcrofts should invest this money to supplement any retirement accounts they may have, and we will assume since they both have good jobs that they are contributing the maximum to their tax-sheltered retirement plans (if not, your first recommendation would be to fully fund all of these plans and/or IRAs). Next, have the Ashcrofts look over their balance sheet and see what rates they are paying on their debts. Particularly look at debts where the interest is not tax deductible (credit cards, personal loans, auto loans, etc.). Paying down high rate debt provides a guaranteed rate of return at the rate of the debt (if you’re paying on the debt, you’re paying out that rate of return; if you no longer have that debt, you are keeping that rate of return in your pocket and have it to invest). Having done these preliminaries, you would probably want to recommend a portfolio consisting mostly of diversified, high-quality stocks for long-term growth and some bonds to act (hopefully) as a cushion when the market goes down. Students will develop a portfolio from listings in Exhibits 11.5 and 12.10, with the exception of the money market mutual fund. Using only the two exhibits in the text limits the choices, obviously, and does not make for as diversified a portfolio as would be desired, but you will notice in the portfolio should have a representation of various industries. About two-thirds of the portfolio should be comprised of stocks while the other third should be fixed income securities. The bonds were chosen because they mature in a fairly short time period. At the time the portfolio was created, the prevailing interest rates were very low, so the idea was to buy shorter-term bonds and repurchase when interest rates rise. Shorter-term bonds have less price volatility and suffer less loss in value than do longer-term bonds when interest rates go up. Note that while Treasuries of the same maturity offered higher coupons, they were selling at larger premiums, making their yields lower than the corporate bond chosen. 12.2 Elaine Decides to Try Her Hand at Investing 1. Numerous options are open to Elaine, but due to her fairly conservative disposition, probably only high-quality bonds, blue chip common stocks, and high-quality growth stocks, as well as certain savings instruments, like certificates of deposit, are candidates for investment. The bonds falling into this category could be corporate, municipal, or federal government issues. 2. Historically, stocks have outperformed bonds, so Elaine has a good chance of earning a satisfactory return with any of the different stocks listed. However, the growth and speculative stocks will carry greater risk, particularly the speculative stocks. Whether Elaine earns an acceptable return on the bonds depends not only on the bond returns but also on her tax situation. Corporate bonds pay interest which would be taxed at her regular tax rate. The income from qualified municipal bonds is free from federal income taxes, but the yields on municipals are generally lower than those on corporate bonds. 3. Income vs. growth—Elaine is living comfortably and has been able to save quite a bit. Therefore, she probably does not want to invest with an income objective but rather with a growth orientation. Short-term vs. long-term—Elaine probably would want to invest this money for the long term, as she does not need it anytime soon and her salary is sufficient for her current living needs. Additionally, Elaine has given herself an emergency fund of $3,000 to handle any unexpected expenses. Level of risk—The risk-return trade off should also be considered when analyzing Elaine’s investment choices so as to maximize her return without exposing her to an unacceptable level of risk. 4. Suitable recommendations for Elaine’s portfolio would probably include some mixture of high-quality stocks and bonds, perhaps half and half or 60% stocks and 40% bonds. The stock portion should be comprised mostly of blue chips with perhaps several quality growth stocks. The bond portion should be comprised of investment grade short-term and intermediate-term bonds, as long-term bonds are subject to greater price fluctuations when interest rates change. Solution Manual for PFIN Personal Finance Michael D. Joehnk, Randall S. Billingsley, Lawrence J. Gitman 9781305271432
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