CH-11-12 Investing in Stocks – Personal Finance : Book Guide

This Document Contains Chapters 11 to 12 11 INVESTING IN STOCKS CHAPTER OVERVIEW Initially, this chapter describes both common and preferred stock as investment alternatives. We discuss the topics of why corporations sell common stocks and why investors purchase those stocks. Next, we examine the major differences between common stock and preferred stock. We also describe the cumulative, participation, and conversion features that can make preferred stock a more attractive investment. Methods that investors can use to evaluate stock investments are presented. The steps involved in buying and selling stocks are described. We also explain the long-term techniques of buy and hold, dollar cost averaging, direct investment plans, and dividend reinvestment plans. Finally, the speculative techniques of margin transactions, selling short, and stock options are also discussed. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Identify the most important features of common stock. Corporations sell common stock to finance their business start-up costs and help pay for their ongoing business activities. People invest in common stock because of dividend income, appreciation of value, and the possibility of gain through stock splits. Dividend payments must be approved by a corporation’s board of directors. In return for providing the money needed to finance the corporation, shareholders have the right to elect the board of directors. They must also approve changes to corporate policies that include (1) an amendment to the corporate charter, (2) the sale of certain assets, (3) possible mergers, (4) the issuance of preferred stock or corporate bonds, and (5) changes in the amount of common stocks. Obj. 2 Discuss the most important features of preferred stock. The most important priority that an investor in preferred stock enjoys is receiving cash dividends before any cash dividends are paid to common shareholders. Still, dividend distributions to both preferred and common shareholders must be approved by the board of directors. To make preferred stock issues more attractive, corporations may add a cumulative feature, a participating feature, and/or a conversion feature to these issues. Obj. 3 Explain how you can evaluate stock investments. A number of factors can make a share of stock increase or decrease in value. When evaluating a particular stock issue, most investors begin with the information contained in daily newspapers or on the Internet. Classification of stocks, stock advisory services, annual reports, quarterly reports, information in business periodicals, numerical measures, and the fundamental, technical, and efficient market investment theories can all be used to help evaluate a stock investment. LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 4 Describe how stocks are bought and sold. A corporation may sell a new stock issue through an investment bank or directly to current shareholders. Once the stock has been sold in the primary market, it can be sold time and again in the secondary market. In the secondary market, investors purchase stock listed on a securities exchange or traded in the over-thecounter-market. Most securities transactions are made through an account executive or stockbroker who works for a brokerage firm. A growing number of investors are using computers to complete security transactions online. In fact, a good investment software package can help you evaluate potential investments, monitor the value of your investments, and place buy and sell orders on line. Most brokerage firms charge a minimum commission for buying or selling stock. Additional commission charges are based on the number and value of the shares that are bought and sold and if you use a full-service or discount broker or trade online. Individual states and the federal government have enacted a number of regulations to protect investors. Obj. 5 Explain the trading techniques used by longterm investors and shortterm speculators. Purchased stock may be classified as either a long-term investment or a speculative investment. Long-term investors typically hold their investments for at least a year or longer; speculators (sometimes referred to as traders) usually sell their investments within a shorter period of time. Traditional trading techniques used by long-term investors include the buy and hold technique, dollar cost averaging, direct investment plans, and dividend reinvestment plans. More speculative techniques include buying on margin, selling short, and trading in options. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 327). • Point out the learning objectives (p. 327) in an effort to highlight the key points in the chapter. • Ask students to share various attitudes toward investing in stock (p. 331). • Discuss factors that would make certain stocks an attractive investment. (p. 331) CHAPTER 11 OUTLINE I. Common Stock A. How are the Markets Doing? B. Why Corporations Issue Common Stock C. Why Investors Purchase Common Stock II. Preferred Stock A. The Cumulative Feature of Preferred Stock B. The Participation Feature of Preferred Stock C. The Conversion Feature of Preferred Stock III. Evaluation of a Stock Issue A. Classification of Stock Investments B. How to Read the Financial Section of the Newspaper C. The Internet D. Stock Advisory Services E. Corporate News F. Factors that Influence the Price of a Stock G. Measures of Corporate Risk, Performance, and Shareholders’ Returns IV. Buying and Selling Stocks A. Primary Markets for Stocks B. Secondary Markets for Stocks C. Brokerage Firms and Account Executives D. Should You Use a Full-Service or a Discount Brokerage Firm? 1. A Sample Transaction 2. Computerized Transactions 3. Commission Charges E. Types of Stock Orders F. Computerized Transactions G. Commission Charges H. Securities Regulation V. Long-Term and Short-Term Investment Strategies A. Long-Term Techniques B. Short-Term Techniques CHAPTER 11 LECTURE OUTLINE Instructional Suggestions COMMON STOCK (p. 328) • Investor’s face two concerns when they begin an investment program: Where to get the information needed to evaluate potential investments and how to interpret they information they find. • Discussion Question: How many of you own stock in a corporation? • Discussion Question: Why do corporations issue common stock? • Discussion Question: What types of issues do shareholders vote on? How are the Markets Doing? (p. 328) • • When people talk about “the market”, they are actually referring to an index, a statistical measure of the changes in a portfolio of stocks representing a portion of the overall market. The most popular indexes are: S&P/TSX Composite index, Dow Jones Industrial Average, NYSE Composite index, Nasdaq Composite index, and the Standard and Poor’s 500 stock index. Why Corporations Issue Common Stock (p. 330) • • Corporations sell common stock to finance their business start-up costs and help pay for their ongoing activities. • A private corporation is a corporation whose stock is owned by relatively few people and is not traded openly in stock markets. A public corporation is a corporation whose stock is traded openly in stock markets and may be purchased by an individual. • Corporate managers prefer selling common stock for a number of reasons. 1. It is a form of equity and does not have to be repaid. 2. Dividends must be approved by the board of directors and are not mandatory. In return for the financing, management must make concessions to shareholders that may restrict corporate policy. 1. Corporations are required to have an annual meeting. (Most shareholders vote by proxy.) 2. Common shareholders elect the board of directors and approve major changes in corporate policies. 3. Most states require that a provision for preemptive rights be included in the charter of every corporation. Finally, corporations are required by law to distribute annual and quarterly reports to shareholders. • Discussion Question: How do you make money when you invest in common stocks? • Text Highlight: You may want to review the typical information about dividends presented in Exhibit 11-3 with students. Why Investors Purchase Common Stock (p. 331) • Text Highlight: You may want to discuss the boxed insert entitled, “When Should You Sell a Stock?” on page 332. • How do you make money by buying stock? An investment in common stock can increase in value in three ways. 1. Income from dividends 2. Dollar appreciation of stock value 3. Possibility of increased value from stock splits • A sample stock transaction for Indigo Books and Music is presented in Exhibit 11-4. The investor received both dividends and profit when the stock was sold. • Concept Check 11-1 (p. 333) • Discussion Question: Why would a corporation want to call its preferred stock? PREFERRED STOCK (p. 333) • • • The most important priority that an investor in preferred stock enjoys is receiving cash dividends before common shareholders are paid any cash dividends. The dividend for preferred stock is known before the stock is purchased. The dividend amount is either a stated amount of money or a certain percentage of the par value of the preferred stock. Preferred stocks are often referred to as a middle investment between common stock (an ownership position) and corporate bonds (a creditor position). • Preferred stocks lack the growth potential that common stocks offer and the safety of many corporate bond issues. Therefore, preferred stocks are generally considered a poor investment for most investors. • While preferred stock does not represent a legal debt that must be repaid, if the firm is dissolved or declares bankruptcy, preferred shareholders do have first claim to the corporation’s assets after creditors. Generally, a preferred stock issue is callable—a corporation may recall its preferred stock at its option for a specified amount of money. Corporations issue preferred stock because it is an alternative method of financing that may attract investors who do not wish to buy common stock or corporate bonds. • • CHAPTER 11 LECTURE OUTLINE Instructional Suggestions The Cumulative Feature of Preferred Stock (p. 334) • The corporation may vote not to issue dividends in a particular quarter; however that does not mean that they don’t ever have to pay the omitted dividend. Preferred shares are cumulative, so omitted dividends just accumulate and must be paid at a later date. The Participation Feature of Preferred Stocks (p. 334) • The participation feature allows preferred shareholders to share with the common shareholders in the company’s earnings. The Conversion Feature of Preferred Stock (p. 335) • Convertible preferred stock is preferred stock that can be exchanged, at the shareholder’s option, for a specified number of shares of common stock. The conversion feature provides the investor with the safety of preferred stock and the possibility of greater speculative gain through conversion to common stock. EVALUATION OF A STOCK ISSUE (p. 335) Stock Valuation (p. 336) • There are two different approaches to analyzing stocks. Fundamental analysis values stock by looking at micro and macro factors that might influence its economic value. Technical analysis is the idea that changes in investor sentiment are responsible for changes in trends and that the value of a stock can be predicted by extrapolating price from historical patterns. EMH contradicts technical analysis as it states future prices cannot be predicted from past trends and prices. • Concept Check 11-2 (p. 335) Classification of Stock Investments (p. 336) • 1. 2. 3. 4. 5. 6. 7. 8. We describe six classifications for stock investment that are commonly used by investors, financial planners, and stockbrokers. They are: Blue chip stocks—very safe investments that generally attract conservative investors. Income stocks—stocks that pay higher than average dividends. Growth stocks—stocks issued by corporations that earn profits above the average profits of all the firms in the economy. Cyclical stocks—stocks that follow the business cycle of advances and declines in the economy. Defensive stocks—stocks that remain stable during declines in the economy. Large-cap stocks—stocks issued by a large corporation that has a large amount of stock outstanding and a large amount of capitalization. Small-cap stocks—stocks issued by a corporation that has a capitalization of $150 million or less. Penny stocks—stocks that typically sell for less than $1 a share. How to Read the Financial Section of the Newspaper (p. 338) • A wealth of information is available to investors in stock, and a logical place to start is with the information in the daily newspaper. • Although not all newspapers print exactly the same information, the basic information is usually provided. Stocks are listed alphabetically, so your first task is to move down the table to find the stock you’re interested in. • Then, to read the stock quotation, you simply read across the table—See Exhibit 11-5 on page 338. • If a corporation has more than one stock issue, the common stock is always listed first. Preferred stock issues are indicated by the letters “pf” that follow the company’s name. • Discussion Question: What factors would lead an investor to choose a bluechip stock? An income stock? etc. The Internet (p. 339) As pointed out in the last chapter, it is impossible to describe all the Web sites that deal with personal finance and investments. We will examine some Web sites that are logical starting points when evaluating stock investments. These include: 1. A corporation’s home page 2. Web sites like Canada.com 3. Professional advisory services like SEDAR, Standard & Poor’s, Moody’s, and Value Line • Text Highlight: Have students examine Exhibits 11-6 and 11-7 (pp. 339340). • Text Highlight: You may want to discuss the “Getting to the Basics of Annual Reports” boxed feature. (p. 343) Stock Advisory Services (p. 339) • In choosing among the hundreds of stock advisory services that charge fees for their information, the investor must be concerned about both the quality and the quantity of the information they provide. • Three popular advisory services are: 1. SEDAR 2. Standard & Poor’s Reports 3. Value Line Corporate News (p. 342) • • The federal government requires corporations selling new issues of securities to disclose information about corporate earnings, assets, and liabilities, products or services, and the qualifications of top management in a prospectus that they must give to investors. In additional to a prospectus, all publicly owned corporations send their shareholders an annual report and quarterly reports that contain detailed financial data. Factors that Influence the Price of a Stock (p. 343) • • A bull market develops when investors are optimistic about the overall economy and buy stocks. A bear market develops when investors are pessimistic about the overall economy and sell stocks. • Text Highlight: Have students read the Advice from a Pro on how to spot online investment scams on p.345. • Text Reference: You may want to cover the examples and formulas that are included in this section of Chapter 11. Measures of Corporate Risk, Performance, and Shareholders’ Returns (p. 344) • Annual shareholder return is a stock’s annual dividend and increase in value divided by its dividend and increase in value divided by its beginning-of-year stock price divided by its beginning-of-year stock price, it is referred to as its trailing dividend yield • • Dividend yield is a stock’s annual dividend Capital Gains yield is a stock’s increase in value divided by its beginning-of-year stock price. Earnings per Share are a corporation’s after-tax earnings divided by the number of outstanding shares of common stocks. Price-earnings ratio is the price of a share of stock divided by earnings per share. Beta is the stocks measure of systematic risk. • • • BUYING AND SELLING STOCKS (p. 347) • 1. 2. 3. 4. To purchase common or preferred stock, you generally have to work through a financial representative. In turn, your financial representative must buy the stock in either the primary market or the secondary market. The primary market is a market in which an investor purchases financial securities (via an investment bank or other representative) from the issuer of these securities. An investment bank is a financial firm that assists organizations in raising funds, usually by helping sell new security issues. An initial public offering (IPO) occurs when a corporation sells stock to the general public for the first time. The secondary market is a market for existing financial securities that are currently traded between investors. • Concept Check 11-3 (p. 346) • Discussion Question: What is the difference between the primary market and the secondary market? • Discussion Question: What factors influence the commission that an investment bank charges? • Discussion Question: Why would a corporation want to sell new securities directly to shareholders without the services of an investment bank? Primary Markets for Stocks (p. 347) • Corporations use two methods to sell a new issue of stock. 1. A large corporation may use an investment bank to sell and distribute the new stock issue. a. The investment bank’s commission or spread ranges from less than one percent to as much as 25 percent of the gross proceeds received by a corporation issuing common stock. b. If the stock issue is too large for one investment bank, a group of investment bankers may form an underwriting syndicate. 2. A corporation can sell a new issue of securities directly to existing shareholders. Secondary Markets for Stocks (p. 348) • • • To purchase common or preferred stock, you have to work through an employee of a brokerage firm who will buy or sell for you in a securities marketplace, which is either a securities exchange or the over-the-counter market. A securities exchange is a marketplace where member brokers who are representing investors meet to buy and sell securities. The Toronto Stock Exchange is one of the largest securities exchange in Canada. • • • The TSX Venture Exchange and various provincial exchanges also transact stocks for corporations and investors. The over-the-counter (OTC) market is a network of dealers who buy and sell the securities of corporations that are not listed on a securities exchange. Most over-the-counter securities are traded through NASDAQ—an electronic marketplace for almost 4,100 stocks. Brokerage Firms and Account Executives (p. 348) • • • • An account executive is a licensed individual who buys or sells securities; also called a stockbroker. Most account executives also provide securities information and advise their clients regarding investments. Account executives may err in their investment recommendations. To help avoid a situation in which your account executive’s recommendations are automatically implemented, you should be actively involved in your investment program. In particular, avoid letting your broker use his or her discretion with regard to your account. Also, watch for the practice of churning. • Current Example: RBC Dominion Securities is the largest brokerage firm in Canada. Should You Use a Full-Service or a Discount Brokerage Firm? (p. 349) • Today, a healthy competition exists between fullservice brokerage firms and discount brokerage firms. When deciding which to use you should consider: CHAPTER 11 LECTURE OUTLINE Instructional Suggestions 1. The amount of research information that is available and how much it costs. 2. How much help you need when making an investment decision. 3. How easy it is to buy or sell stock and other securities. Types of Stock Orders (p. 350) • • Text Highlight: You may want to discuss the seven questions that can be used to help investors decide if they need a full-service or discount brokerage firm. • Discussion Question: Why would an investor use a limit order or a stop order? • Current Example: The largest discount brokerage firm is TD Waterhouse. It generally charges more than other discounters because of the elaborate services they offer. Once an investor and his or her account executive have decided on a particular transaction, the investor gives the account executive an order for that transaction. 1. A market order is a request that a stock be bought or sold at the current market price. 2. A limit order is a request that a stock be bought or sold at a specified price. 3. A stop order is a request that an order be executed at the next available opportunity after the market price reaches a specified price. Computerized Transactions (p. 351) • While most people still prefer to use telephone orders to buy and sell stocks, a growing number of investors are using computers to complete security transactions. Commission Charges (p. 351 • Most brokerage firms have a minimum commission charge for buying or selling stock, usually between $25 and $55. Additional commission charges are based on the number of shares and the value of stock bought and sold. 1. A round lot is 100 shares or multiples of 100 shares of a particular stock. 2. An odd lot is fewer than 100 shares of a particular stock. Brokerage firms generally charge more for odd lot transactions. 3. Also, the commission charged by a full-service broker is generally higher than the commission charged by a discount broker. • See Exhibit 11-8 to see typical charges for trades, research, and extras charged by a number of brokerage firms. ecurities Regulation (p. 351) • Government regulation of securities trading began as a response to abusive and fraudulent practices in the sale of stocks. • The general principle underlying the legislation is to ensure that full, true, and plain disclosure of all relevant facts is made by sellers of securities to the public. LONG-TERM AND SHORT-TERM INVESTMENT STRATEGIES (p. 353 • Generally, individuals who hold an investment for a long period of time are referred to as investors. Individuals who buy and then sell stocks within a short period of time are called speculators or traders. • Concept Check 11-4 (p. 353 Long-Term Techniques (p. 353 • 1. 2. 3. 4. Long-term investment strategies include: The buy and hold technique Dollar cost averaging—See Exhibit 11-9 Direct investment Dividend reinvestment plans Short-Term Techniques (p. 353) • In addition to the long-term techniques presented in the preceding section, we discuss several short-term, speculative techniques. These methods are quite risky and should not be used by investors who do not fully understand the underlying risks. Buying Stock on Margin (p. 355 • • When buying stock on margin, an investor borrows part of the money necessary to buy a particular stock. The steps of a typical margin transaction are illustrated in Exhibit 11-10. Selling Short (p. 356 • • • • Investors oriented to greater risk often use a procedure called selling short to make money when the price of a security is falling. Selling short is selling stock that has been borrowed from a stockbroker and must be replaced at a later date. The steps involved in selling short are illustrated in Exhibit 11-11. Trading in Options (p. 357) • An option gives an investor the right to buy or sell stock at a predetermined price during a specified period. 1. A call option is sold by a shareholder and gives the purchaser the right to buy 100 shares of a stock at a guaranteed price before a definite expiration date. 2. A put option is the right to sell 100 shares of a stock at a guaranteed price before a definite expiration date. CONCLUDING ACTIVITIES Discussion Question: Why would an investor use the selling short procedure? Chapter Highlight, Exhibit 11-12 (p.357)for a graphical representation of the payoffs of options. • Concept Check 11-5 (p. 358 • Point out the chapter summary (pp. 358) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 11 QUIZ ANSWERS True-False 1. T 2. F 3. T 4. F 5. F 6. F 7. T 8. F Multiple Choice 9. B 10. B 11. A 12. D 13. C 14. B 15. D 16. B Name ________________________________________ Date____________________________ CHAPTER 11 QUIZ TRUE-FALSE _____1. _____2. _____3. Corporations sell common stock to finance their business start-up costs and help pay for their ongoing business activities. An income stock pays lower than average dividends. _____5. The record date is the date when a shareholder must be registered on the corporation’s books in order to receive dividends. The participation feature of preferred stock allows the investor to exchange their preferred stock into a specified number of shares of common stock. A blue-chip stock is a very risky investment. _____6. A bull market occurs when investors are pessimistic about the economy and sell their stocks. _____7. If you buy stocks on margin you are borrowing part of the money needed to purchase a particular stock. A corporation is required by law to pay dividends to stockholders. _____4. _____8. MULTIPLE CHOICE _____9. Which of these is not a long-term investment technique for diversification? a. buy and hold b. dividend distribution program c. dollar cost averaging d. dividend investment program _____10. A stock split a. always guarantees that the investor will make money. b. enables management to bring a stock’s price into an “ideal” price range. c. is always used to lower the stock’s market price. d. doesn’t affect the value of the individual’s investment. _____11. A feature that enables preferred stock investors to receive omitted dividends is called a ____________ feature. a. cumulative b. participation c. conversion d. callable _____12. A stock that follows the business cycle of advances and declines in the economy is called a(n) ____________ stock. a. blue-chip b. income c. growth d. cyclical _____13. When stocks are traded between investors, they are traded in the ____________ market. a. investment banking b. primary c. secondary d. efficient. _____14. ___________ can be converted to common shares for a pre-determined price. a. Callable preferred stock b. Convertible preferred stock c. Cumulative preferred stock d. Tired preferred stock _____15. A(n) ___________ is a stock that typically sells for less than one dollar per share. a. Defensive stock b. Large-cap stock c. Small-cap stock d. Penny stock _____16. At an annual meeting, stockholders can either vote in person or by ____________ . a. ad hoc ballot. b. proxy. c. record ballot. d. cumulative feature. SUPPLEMENTARY LECTURE This lecture can be used to illustrate how a computer can help an investor monitor his or her investments. Introduction If you follow stock quotations and dream about the fortune you could make if only you had $10,000 to invest, sometime in the future you are likely to enter the relatively new world of computerized investing. Hardware Requirements To begin with, the home investor needs a powerful personal computer, a good printer, and a modem. What Type of Information Is Available There are hundreds of on-line services and thousands of databases that can be accessed with a computer and modem. Typically, services that offer immediate (or real-time) stock quotations charge $50 to $200 for equipment and initial installation, and a monthly fee. It is also possible to obtain stock quotations on a delayed basis—fifteen to twenty minutes after the transactions—for free by using a search engine like Canada.com or numerous other Web sites. Finally, it is possible to subscribe to one of the services that provide online research information or monthly disks full of information about selected companies in specific industries. Analyzing All the Numbers With so much information readily available, most investors need a portfolio-analysis program to help them take sense of all the figures. Such programs can do mundane clerical chores like keeping track of the value of your portfolio, measuring the value against the TSE 300 Index, and calculating current yields. ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 11-1 (p. 333) 1. If you needed information about a stock investment, would you go to the library or the Internet? Why? While students’ answers may vary, you may want to use this question to discuss how an Internet site like Canoe.ca can help investors. Encourage investors to try it out—they may be surprised at how easy it is to obtain research information about not only stock investments, but other investments. 2. Why do corporations issue common stock? Corporations sell common stock to finance their business start-up costs and help pay for their ongoing business activities. Since common stock is a form of equity financing, it does not have to be repaid and dividends are not necessary. (p. 328) 3. What are the typical issues on which shareholders vote? Common shareholders elect the board of directors, must approve major changes in corporate policies, and vote on current or evolving issues that affect the corporation. 4. Describe two reasons why shareholders purchase common stock. There are several ways that an investor can make money with a common stock investment. Some of these include (1) income from dividends; (2) dollar appreciation of stock value; and (3) possibility of increased value from stock splits. (p. 331) Concept Check 11-2 (p. 335) 1. What is the most important priority that a preferred shareholder has when compared to common shareholders? The most important priority that an investor in preferred stock enjoys is receiving cash dividends before common shareholders are paid any cash dividends. (p. 333) 2. Why would a corporation call a preferred stock issue? If interest rates and dividends in the economy are decreasing and similar investments provide a smaller return than the corporation’s preferred stock issue, management may decide to call in the preferred issue and substitute a new preferred stock issue that pays a lower dividend. Management may also decide to call in the preferred stock issue and issue common stock with no specified dividend. (p. 333) 3. Why do corporations issue preferred stock? Preferred stock is an alternative method of financing that may attract investors who do not wish to buy a corporation’s common stock. (p. 333) 4. Describe three features that corporations can offer to make preferred stock issues more attractive. Cumulative preferred stock is a stock issue whose unpaid dividends accumulate and must be paid before any cash dividend is paid to the common shareholders. The participation feature allows preferred shareholders to share in the earnings of the corporation with the common shareholders. The conversion feature allows preferred shareholders to exchange their stock, at their option, for a specified number of shares of common stock. (p. 334) Concept Check 11-3 (p. 346) 1. What sources of information would you use to evaluate a stock issue? Newspapers and the Internet are the most readily available source of information about stock investments. In this section, classifications of stocks, corporate reports, stock advisory services, numerical measures for stock, and investment theories were also discussed. (pp. 335-336) 2. How would you define: (1) a blue-chip stock, (2) an income stock, (3) a growth stock, (4) a cyclical stock, (5) a defensive stock, (6) a penny stock, (7) a large-cap stock, and (8) a small-cap stock? a. A blue-chip stock is a very safe investment that generally attracts conservative investors. b. An income stock is a stock that pays higher than average dividends. c. A growth stock is a stock issued by a corporation earning profits above the average profits of all the firms in the economy. d. A cyclical stock is a stock that follows the business cycle of advances and declines in the economy. e. A defensive stock is a stock that remains stable during declines in the economy. f. A penny stock is a stock that typically sells for less than $1. g. A large-cap stock is a stock issued by large corporations that have a large amount of stock outstanding and a large amount of capitalization. h. A small-cap stock is a stock issued by a company that has a capitalization of $150 million or less. (pp. 336-337) 3. What do the terms annual shareholder return, dividend yield, capital gains yield, earnings per share, price-earnings ratio and beta refer to? The current yield is the yearly dollar amount of income generated by an investment divided by the current market value. The annual shareholder return is the current return plus capital gains. Earnings per share are a corporation’s after-tax earnings divided by the number of outstanding shares of common stock. The price-earnings ratio is the price of a share of stock divided by the corporation’s earnings per share of stock outstanding over the last 12 months. Beta is the measure of systematic risk for the stock. (p. 345) Concept Check 11-4 (p. 353) 1. What is the difference between the primary market and the secondary market? The primary market is a market in which an investor purchases financial securities (via an investment bank or other representative) from the issuer of those securities. The secondary market is a market for existing financial securities that are currently traded between investors. (p.347) 2. Describe how stocks are bought and sold in the secondary market. While discussing the answer to this question, you may want to discuss how stock is traded at a securities exchange or through the over-the-counter-market (p. 347). 3. Assume you want to purchase stock. Would you use a full-service broker or a discount broker? Would you ever trade stocks online? While students must answer this question, you may want to review Exhibit 11-8—Typical Commission Charges and Services Provided By Online Brokerage Firms—on page 350. At this time, computerized trading is becoming more popular, but most investors still prefer more traditional methods. (p. 349) Concept Check 11-5 (p. 358) 1. Why is it better for investors to diversify their stock portfolios? Diversification allows an investor to spread out risk amongst different securities, which minimizes the overall risk of the portfolio. (p. 353) 2. How can an investor make money using the buy and hold technique? When investors use a buy and hold technique, investors can make money in one of three ways. First, they are entitled to dividends. Second, the price of the stock may go up. Third, the stock may split. (p. 353) 3. What is the advantage of using dollar cost averaging? Investors use dollar cost averaging to avoid the common pitfall of buying high and selling low. (p. 353) 4. Explain the difference between direct investment plans and dividend reinvestment plans. Direct investment plans allow shareholders to purchase stocks directly from a corporation without having to use an account executive or a brokerage firm. A dividend reinvestment plan allows current shareholders the option of reinvesting their cash dividends in the stock of a corporation. (p. 353) 5. What role does a private equity firm play in a typical leveraged buyout? Private equity is an asset class consisting of equity securities in companies that are not publicly traded in a stock exchange. Investments in private equity generally involve either injecting capital into or acquiring a company. Typically, institutional investors provide capital for private equity. In a classic leveraged buyout transaction, an existing or mature firm’s majority control is purchased by the private equity firm. This differs significantly from a venture capital or growth capital investment, in which the private equity firm rarely obtains majority control, but instead invests in an emerging company 6. Why would an investor buy stock on margin? When buying stock on margin an investor borrows part of the money necessary to buy a particular stock. The financial leverage of borrowed money allows the shareholder to purchase a larger number of shares of stock. If the price of the stock increases, the shareholder makes money because he or she owns more shares. (p. 355) 7. Why would an investor use the selling short technique? Shareholders who think the market value of a stock will decrease, may want to use the selling short technique. When you sell short, you sell today, knowing that you must buy or cover your short transaction later. (p. 356) 8. What is the primary aim of a hedge fund? A hedge fund is an investment fund that serves a select group of investors using an investment strategy that is not limited only to funds that are expected to increase in value. A hedge fund pays a performance fee to its investment manager, whose principle goal is to deliver positive returns by mitigating risk, minimizing volatility, and preserving capital. (p. 358) OPENING CASE QUESTIONS p. 327 1. How important is the evaluation of a stock issue and the financial condition of a company when making a decision to buy or sell the company’s stock? Explain your answer. For Jason Godwin, the investor in the opening case, evaluation paid off. The fact is that there is really no substitute for evaluating an investment. Only when you know the facts, can you make an intelligent investment decision. 2. If you needed to obtain financial data to make a decision to buy or sell a company’s stock, would you go to the library or the Internet? Why? Three years ago, most people would have answered “library.” Today, more and more people are using the Internet and certainly, investors are no exception. FINANCIAL PLANNING PROBLEMS p. 360 1. Jennifer and Jeff Cooke own 220 shares of Petro-Canada common stock. Petro-Canada’s quarterly dividend is $10 per share. What is the amount of the dividend check that the Cooke couple will receive for this quarter? Quarterly dividend = 220 shares × $10 = $2,200 2. Tamara June purchased 100 shares of All-Canadian Manufacturing Company stock at $29 1/2 a share. One year later, she sold the stock for $38 a share. She paid her broker a $34 commission when she purchased the stock and a $42 commission when she sold it. During the 12 months that she owned the stock, she received $184 in dividends. a. Calculate Tamara’s annual shareholder return. b. Break this total down into its components: dividend yield and capital gains yield. Current Return = $184 in dividends over the past 12 months Purchase Price = $29.50 × 100 shares + $34 commission = $2,984 Dividend yield = 184/(2950) = .062 Selling Price = $38 × 100 shares - $42 commission = $3,758 Capital gain = $3,758 - $2,984 = $774 Capital gains yield = 774/2950 = .26 Total Return = $184 Current Return + $774 = Capital Gain of $958. Annual shareholder return = .26 +.062 = .322 or 32.2% 3. Calculating Annual Rate of Return. You bought 100 shares of stock at $25 each. At the end of year 1 you received $400 in dividends and at the end of year 2, you received in $100 in dividends and your stock was worth $2,700. What annual rate of return did you earn of your investment? Answer: 2500 + $400/(1+r)1 +($100 +$2700)/(1+r)2 = 0 4. Marie and Brian Hume purchased 100 shares of a Canadian utility stock in January 2008 They calculated annual shareholder return to be 5%, -3% and 7% for the years 2008, 2009 and 2011, respectively. What was the annual average compound return of their investment to the end of 20011? Solution: Annual average compound return = [(1.05)(1 - 0.03)(1 + 0.07)]1/3 – 1 = 0.029 or 2.9 percent. 5. Thom Hayes owns Gaz Métropolitain preferred stock. If this preferred stock issue pays 6 l/4 percent based on a par value of $25, what is the dollar amount of the dividend for one share of Gaz Métropolitain? $25 par value × 0.0625 = $1.56 per share dividend. (p. 334) 6. A sports equipment company issued a $3 cumulative preferred stock issue. In 2010 the firm’s board of directors voted to omit dividends for both the company’s common and preferred stock issues. Also, assume that the corporation’s board of directors votes to pay dividends in 2011 a. How much did the preferred shareholders receive in 2010? Because of the board’s action, preferred shareholders received $0 in 2010. b. How much did the common shareholders receive in 2010? Because of the board’s action, common shareholders received $0 in 2010. c. How much did the preferred shareholders receive in 2011? Cumulative preferred shareholders received $6 in 2011, as illustrated below. $3 (2000 omitted dividend) + $3 (2001) = $6 total dividend 7. Two years ago, you purchased 100 shares of a cola company. Your purchase price was $50 a share, plus a commission of $5 per share, for a total cost of $55 per share. After one year, the stock’s market value had risen to $58. At the end of two years, you sold your cola company stocks for $68 a share, less a per-share commission of $2. During the two years you held the stock, you received dividends of $0.56 per share for the first year and $0.68 per share for the second year. (Obj. 3) a) Calculate your annual shareholder return for each of the two years you owned the stock. b) Calculate your annual a verage compound return. Solution a) Annual shareholder return of year 1 = [($58 + $0.56) – $55] ÷ $55 = 0.065 or 6.5 percent Annual shareholder return of year 2 = [($66 + $0.68) - $58] ÷ $58 = 0.150 or 15 percent b) Annual average compound return = [(1.065)(1.15)]1/2 – 1 = 0.1067 or 10.7 percent 8. As a shareholder of an oil company, you receive its annual report. In the financial statements, the firm has reported assets of $9 million, liabilities of $5 million, after-tax earnings of $2 million, and 750,000 outstanding shares of common stock. a. Calculate the earnings per share of this oil company’s common stock. = $2 million = 2.67 After-Tax Earnings # of common shares outstanding 750,000 shares b. Assuming that a share of this oil company’s common stock has a market value of $40, what is the firm’s price-earnings ratio? Market Value = 40 = 14.98 EPS 2.67 9. For four years, Marie St. Louis invested $3,000 each year in Canada Bank stock. The stock was selling for $34 in 2008, for $48 in 2009, $37 in 2010 and for $52 in 2011. a. What is Marie’s total investment in Canada Bank? Marie’s total investment is $12,000, as illustrated below. $3,000 x 4 years = $12,000 total investment. b. After four years, how many shares does Marie own? Marie owns 289.5 shares, as illustrated below. 2008 $3,000 ÷ $34 = 88.2 shares 2009 62.5 shares $3,000 ÷ $48 = 2010 81.1 shares $3,000 ÷ $37 = 2011 57.7 shares $3,000 ÷ $52 = Total Shares 289.5 shares c. What is the average cost per share of Marie’s investment? The average cost per share is $41.45, as illustrated below. $12,000 total investment ÷ 289.5 shares = $41.45 per share cost. 10. Brian Campbell invested $4,000 and borrowed $4,000 to purchase shares in a large retailing company. At the time of investment, the stock was selling for $45 a share. a. If Brian paid $70 commission, how many shares could he buy if he used only his own money and did not use margin? $4,000 - $70 commission = $3,930 funds for investment after commission $3,930 / $45 a share = 87.3 shares b. If Brian paid $100 commission, how many shares could he buy if he used his $4,000 and borrowed $4,000 on margin to buy the retailing company’s stock? $4,000 + $4,000 Margin = $8,000 total funds available for investment $8,000 - $100 commission = $7,900 funds for investment after commission $7,900 / $45 a share = 175.6 shares c. Assuming that Brian did use margin, paid $250 commission to buy and sell his stock, and sold his stock for $53, how much profit did he make on his retailing company’s investment? $53 price per share when sold - $45 per share purchase price = $8 per share profit $8 per share profit × 175.6 number of shares using margin = $1,404.80 profit $1,404.80 - $150 commission = $1,254.80 total profit after commissions 11. After researching a software company’s common stock, Sarah Jackson is convinced that the stock is overpriced. She contacts her account executive and arranges to sell short 200 shares. At the time of the sale, a share of common stock had a value of $35. Six months later, the stocks were selling for $23 a share and Sarah instructs her broker to cover her short transaction. Total commissions to buy and sell the stock were $120. What is her profit for this short transaction? $35 per share price when sold - $23 per share when purchased = $12 per share profit $12 × 200 shares = $2,400 profit before commissions $2,400 - $120 = $2,280 total profit after commissions FINANCIAL PLANNING ACTIVITIES p.361 1. Survey investors who own stock, then explain, in a short paragraph, their reasons for owning stock. While student answers will vary, the people they survey should have purchased stock for income from dividends, dollar appreciation of stock value, and possible increase in value from stock splits. 2. Interview an account executive about the cumulative feature, participation feature, and conversion feature of a preferred stock. What do these features mean to preferred shareholders? Cumulative preferred stock is a stock issue whose unpaid dividends or preferred stock accumulate and must be paid before any cash dividend is paid to the common shareholders. The participation feature of preferred stock allows preferred shareholders to share in the earnings of the corporation with the common shareholders. The conversion feature allows preferred shareholders to exchange, at their option, a share of preferred for a specified number of shares of common stock. 3. Divide a sheet of paper into three columns. In the first column, list sources of information that can be used to evaluate stock investments. In the second column, state where you would find each of these sources. In the third column, describe the types of information that each of these sources would provide. While student answers may vary, you can use this question to review the material presented in the major section entitled Evaluation of a Stock Issue. 4. Pick a stock that interests you and research the company at the library by examining the information contained in reports published by Moody’s, Standard & Poor’s, Zack’s, or business periodicals like Canadian Business, IE: Money, Money, or Business Week. Then, write a one or two page summary of your findings. Based on your research would you still want to invest in this stock? Why or why not? Although student answers may vary, you may want to use this question as a reason to discuss the type of information provided by investor services like Moody’s, Standard & Poor’s, and Zack’s—See Exhibits 11- 6 and 11-7. (pp. 339, 340) 5. Choose a stock that you think would be a good investment. Then research the stock using the Internet. a. Based on the information contained in the corporation’s home page, would you still want to invest in the stock. Explain your answer. Answers will vary and depend on the stock students choose for this exercise. b. What other investment information would you need to evaluate the stock? Where would you obtain this information? All of the sources included in the major section “Evaluation of a Stock Issue” included in this chapter could be used to evaluate a specific stock issue. Student answers should include some, if not all, of the following: newspapers, corporate news, stock advisory services. In addition, calculations for book value, earnings per share, and price-earnings ratio could help evaluate a specific stock issue. 6. Conduct library research on the fundamental theory, the technical theory, and the efficient market theory that were discussed in this chapter. How do these theories explain the price movements of a stock traded on the TSE or over-the-counter market? This may be a case where each of the theories has some truth in them. Maybe, their “real value” is when they are combined and the best parts of each are used to explain price movements in the market. 7. Prepare a list of questions you could use to interview an account executive about career opportunities in the field of finance. While each student’s list of questions will vary, each list should include questions about college education, working conditions, number of hours worked, reasonable expectation as related to salaries, job stress, and advancement opportunities. 8. Interview people who have used the long-term investment techniques of buy and hold, dollar cost averaging, direct investment plans, and dividend reinvestment plans. Describe your findings. These techniques are all used by long-term, conservative investors. You may want to remind students that investing for most people is built on a long-term financial plan. In fact, they should not expect to “double their money overnight.” 9. Prepare a chart that describes the similarities and differences among buying stock on margin, selling short, and trading in options. When buying on margin, an investor borrows part of the money necessary to buy a particular stock. Because the investor owns more stock, he or she makes more money if the stock increases in value. Selling short is selling stock that has been borrowed from a stockbroker and must be replaced at a later date. Simply put, the investor sells the borrowed stock at a high price, and then replaces the borrowed stock purchased later at a lower price .An option gives an investor the right to buy or sell 100 shares of a stock at a predetermined price during a specified period of time. All three short-term methods described in this section are speculative and should not be used by anyone who does not understand the risks involved. LIFE SITUATION CASE p. 362 Research Information Available from Zack’s and Globeinvestor GOLD 1. Based on the research provided by Zack’s and Globeinvestor GOLD, would you buy BCE stock? Justify your answer. Each student will have to answer this question based on his or her own investment objectives. All answers should be based on the information contained in Exhibits 11-6 and 11-7. 2. What other investment information would you need to evaluate BCE common stock? Where would you obtain this information? It would be possible to compare the information contained in the Zack’s and Globeinvestor GOLD reports with similar reports. This information would be available in most libraries. It would also be possible to talk to a full-service broker regarding this stock. You could also use the Internet to research BCE. Finally, it would be possible to research the company through business periodicals or an annual report. Again, most libraries have these publications. 3. At year-end 2006, BCE common stocks were selling for $31.40 a share. Using a newspaper, determine the current price for a share of BCE common stock. Based on this information, would your BCE investment have been profitable if you had purchased the common stock for $31.40 a share? Hint: BCE stock is listed on the NYSE. This answer will depend on if the current price obtained by students is higher or lower than the price at year-end 2006. 4. Assume you purchased BCE stock on December 31, 2006. Based on the fact that in June 2007 BCE announced plans to be acquired by a private consortium, would you want to hold or sell your BCE stock. Explain your answer. If the price per share being offered by the consortium is higher than the current market price, you would want to hold your BCE stock. On the other hand, if the current market price was higher than what is being offered, you are better off selling you BCE stock. 12 INVESTING IN BONDS CHAPTER OVERVIEW This chapter describes bonds as an investment alternative. Initially, we examine important characteristics that pertain to bond investments. Then, we discuss the topics of why corporations sell bonds and why investors buy those bonds. Next, the differences between corporate and government bonds, and the factors that investors use to evaluate bond investments are presented. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Describe the characteristics of corporate bonds. A corporate bond is a corporation’s written pledge that it will repay a specified amount of money, with interest. All of the details about a bond (face value, interest rate, maturity, repayment, etc.) are contained in the bond indenture. The trustee is the bondholder’s representative. Obj. 2 Discuss why corporations issue bonds. Corporations issue bonds and other securities to help finance their ongoing activities. Bonds may be debentures, mortgage bonds, subordinated debentures, or convertible bonds. To ensure the money will be available when needed to repay bonds, most corporations establish a sinking bond. Corporations may issue serial bonds that mature on different dates. Obj. 3 Explain why investors purchase bonds. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. The method used to pay bondholders their interest depends on whether they own registered bonds, registered coupon bonds, bearer bonds, or zero-coupon bonds. Because bonds can increase or decrease in value, it is possible to purchase a bond at a discount and hold the bond until it appreciates. Changes in overall interest rates in the economy are the primary causes of most bond price fluctuations. If you pay too much for a bond or it decreases in value, you can lose money on a bond investment. You can also choose to hold the bond until maturity and the corporation will repay the face value of the bond. Corporate bonds can be bought or sold through account executives who represent brokerage firms. LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 4 Discuss why federal, provincial and municipal governments issue bonds and why investors purchase government bonds. Bonds issued by the Canadian government are used to finance the national debt and the ongoing activities of the federal government. The Canadian government issues three principal types of bonds: treasury bills, marketable bonds, and Canada Savings Bonds. Provincial and local governments issue bonds to finance their ongoing activities and special projects such as schools, and toll bridges. Canadian government bonds can be purchased through banks, trust companies, and other financial institutions. Municipal bonds are generally sold through the government entity that issued them or through account executives. Obj. 5 Evaluate bonds when making an investment. Some local newspapers and National Post and The Globe and Mail provide bond investors with some of the information needed to evaluate a bond issue. Detailed financial information can be obtained by requesting a printed copy of the corporation’s annual report or accessing its Web site. It is also possible to trade bonds online and obtain research information via the Internet. To determine the quality of a bond issue, most investors study the ratings provided by the DBRS and Standard & Poor’s. Investors can also calculate a current yield and the yield to maturity. The current yield is determined by dividing the annual interest dollar amount of the bond by its current market value. The yield to maturity takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. INTRODUCTORY ACTIVITIES • Ask students to comment on the opening case for the chapter (p. 363). • Point out the learning objectives (p. 363) in an effort to highlight the key points in the chapter. • Ask students to express opinions they may have about investing in corporate and government bonds • Discuss how different investment objectives can be achieved with various types of bond investments CHAPTER 12 OUTLINE I. Characteristics of Corporate Bonds II. Why Corporations Sell Corporate Bonds A. Types of Bonds B. Convertible Bonds C. Provisions for Repayment D. Other types of bonds III. Why Investors Purchase Corporate Bonds A. Interest Income B. Changes in Bond Value C. Bond Repayment at Maturity D. A comparison of bonds to GIC’s E. A Typical Bond Transaction F. The Mechanics of a Bond Transaction IV. Government Bonds and Debt Securities A. Types of Bonds 1. Government of Canada Securities 2. Marketable Bonds 3. Treasury Bills 4. Canada Savings Bonds 5. Canada Saving Bonds Payroll Program B. Provincial Government Securities C. Municipal Bonds / Installment Debentures V. The Decision to Buy or Sell Bonds A. Annual Reports B. The Internet C. Bond Ratings D. Bond Yield Calculations E. Other Sources of Information VI. Appendix 12: Market Interest Rates and Bond Pricing CHAPTER 12 LECTURE OUTLINE • Today, there are important differences in corporate bonds. Current yield is one factor to consider, but there are other factors. For example, the corporation’s ability to repay the bonds at maturity and the corporation’s ability to continue to pay interest until maturity must also be considered. Instructional Suggestions • Text Highlight: You may want to point out the corporate bond illustrated in Exhibit 12-1 (p. 365). • Text Highlight: Exhibit 12-2 is an advertisement for a 7 ½ percent convertible debenture issued by Meditrust. (p. 365) • Concept Check 12-1 (p. 366) • Discussion Question: Why would a corporation sell corporate bonds? CHARACTERISTICS OF CORPORATE BONDS (p. 364) • • • • • • A corporate bond is a corporation’s written pledge that it will repay a specified amount of money, with interest. The usual face value of a corporate bond is $1,000. The total face value of all bonds issued usually runs into the millions of dollars. Between the time of purchase and the maturity date, the corporation pays interest to the bondholder— usually every six months. The maturity date of a corporate bond is the date on which the corporation is to repay the borrowed money. The actual legal conditions for a corporate bond are described in a bond indenture. Since corporate bond indentures are very difficult for the average person to read and understand, a corporation issuing bonds appoints a trustee to act as the bondholder’s representative. WHY CORPORATIONS SELL CORPORATE BONDS (p. 366) • • Corporations sell corporate bonds to help finance their ongoing business activities. The following factors should be considered: 1. They usually sell bonds when it is difficult or impossible to sell common or preferred stock. 2. The sale of bonds can also improve a corporation’s financial leverage—the use of borrowed funds to increase the corporation’s return on investment. 3. Finally, the interest paid on corporate bonds is a tax-deductible expense and thus can be used to reduce the taxes that a corporation must pay. Corporate bonds are a form of debt financing, whereas stock is a form of equity financing. 1. Bonds must be repaid at a future date. CHAPTER 12 LECTURE OUTLINE Instructional Suggestions 2. Interest payments on bonds are mandatory. 3. In case of bankruptcy, bondholders have a claim to assets of the corporation before shareholders. Types of Bonds (p. 366) • • • A debenture is a bond that is backed only by the reputation of the issuing corporation. To make a bond issue more appealing to investors, a corporation may issue a mortgage bond. A mortgage bond (sometimes called a secured bond) is a corporate bond that is secured by various assets of the issuing firm. 1. A first mortgage bond may be backed up by a lien on a specific asset, usually real estate. 2. A general mortgage bond is secured by all the fixed assets of the firm that are not pledged as collateral for other financial obligations. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to both interest payments and assets. Convertible Bonds and Bond with Warrants (p. 367) • • A convertible bond is a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. There are three reasons why corporations sell convertible bonds: 1. Interest rates on convertible bonds are lower when compared to traditional bonds. 2. The conversion feature attracts investors who are interested in speculative investments. 3. If the bondholder converts, the corporation doesn’t have to repay the bond at maturity. A warrant is an option that is detachable from the associated bond that gives the holder the right to purchase the firm’s common shares at a set price for a pre-determined period. Provisions for Repayment (p. 368) • • Today, most corporate bonds are callable. A call feature allows the corporation to call in or buy outstanding bonds from current bondholders before the maturity date. A corporation may use one of two methods to ensure that it has sufficient funds available to redeem a bond issue. 1. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. • Text Highlight: You may want to discuss the three specific reasons why a corporation would issue convertible bonds at this point in your lecture. • Discussion Question: As an investor, why would you purchase a convertible bond? CHAPTER 12 LECTURE OUTLINE 2. Serial bonds are bonds of a single issue that mature on different dates. Other Types of bonds (p. 368) • • As mentioned earlier in this chapter, bondholders normally receive interest payments every six months. The method used to pay bondholders their interest depends on whether they own registered bonds, registered coupon bonds, bearer bonds, or zerocoupon bonds. Changes in Bond Value (p. 370) • Corporate bonds may increase in value. The price of a corporate bond may fluctuate until the maturity date. Changes in overall interest rates in the economy are the primary cause of most bond price fluctuations. If overall interest rates fall, then a corporate bond with a fixed interest rate will go up in value. On the other hand, if overall interest rates rise, then a corporate bond with a fixed interest rate will go down in value. The financial condition of the corporation and the probability of its repaying the bond also affect the bond’s value. Bond Repayment at Maturity (p. 371) • • Concept Check 12-2 (p. 369) • Discussion Question: Why do investors purchase corporate bonds? • Text Highlight: You may want to refer to the example on determining the interest amount that is included in this section. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. Interest Income (p. 370) • • Domestic, foreign, Eurobond, units, strip bonds. WHY INVESTORS PURCHASE CORPORATE BONDS (p. 366) • Instructional Suggestions Corporate bonds are repaid at maturity. When you purchase a bond, you have two options: You may keep the bond until maturity and then redeem it, or you may sell the bond at any time to another investor. A Comparison of Bonds to GICS (p. 371) • When you invest in GIC’s money goes to a bank, when you invest in bonds money goes to a corporation or a government. Bonds tend to have longer maturities. • A Typical Bond Transaction (p. 372) • • Commissions for bonds, strip coupons, GICs, T-bills, and other fixed income securities are are already included in the quoted price. You purchased an 8.375 corporate bond at $680 and later resold it for $1,030, thereby experiencing a capital gain of $350. The Mechanics of a Bond Transaction (p. 373) • • Most bonds are sold through full-service brokerage firms, discount brokerage firms, or the Internet. The bond market is referred to as an “over-thecounter” (OTC) exchange. Unlike stock markets, there is no centralized floor. Rather, the market is decentralized and transactions are by phone or computer among buyers and sellers. GOVERNMENT BONDS AND DEBT SECURITIES (p. 374) • • • • In addition to corporations, the Canadian government and provincial and municipal governments issue bonds to obtain financing. The federal government sells bonds and securities to finance both the national debt and the government’s ongoing activities. The main reason why investors choose Canadian government securities is that most investors consider them risk free. There are three types of government bonds: marketable bonds, T-Bills, and CSBs. Provincial and Municipal Government Securities (p. 374) • • • Virtually all provinces have bonds available in a wide range of denominations. The term will usually depend on the uses to which the proceeds from the bond sale will be put and the availability of investment funds. Municipalities most often raise capital using the installment debenture, or serial bond. With this type of bond issue, a part will mature every year for its term. Other types of bonds include 1. Mortgage Bonds • Concept Check 12-3 (p. 374) • Discussion Question: Why do investors consider Canadian government bonds to be riskfree investments? • Discussion Question: A few years ago, savings bonds were shunned by most investors. Today some financial planners are recommending CSBs for conservative investors. Would you be interested in CSBs? Under what circumstances? • Text Highlight: You may want to point out the Canadian T-Bill shown in Exhibit 12-3 and the CSB in Exhibit 12-4. (pp. 372, 375) 2. 3. 4. 5. 6. 7. 8. 9. 10. First Mortgage Bonds Collateral Trust Bonds Debentures Corporate Notes Domestic, Foreign, and Eurobonds Bonds and Debentures Carrying Warrants Units Real Estate Bonds Strip Bonds • Concept Check 12-4 (p. 378) • Text Highlight: You may want to spend some time with the material in Exhibit 12-5 (p. 376) at this point in your lecture. THE DECISION TO BUY OR SELL BONDS (p. 379) • • • • • One basic principle that we have stressed throughout this text is the need to evaluate any potential investment. Certainly, corporate and government bonds are no exception. Not all local newspapers contain bond quotations, but The Financial Post publishes complete and thorough information on this subject. Detailed information on how to read bond quotations is provided in Exhibit 12-5. In bond quotations, prices are given as a percentage of the face value, which is usually $1,000. Thus to find the actual price paid, you must multiply the face value ($1,000) by the newspaper quote. For government bonds, two price quotations are included in most financial publications. 1. The first price quotation, or the bid price, is the highest price a dealer is willing to pay for a government security. 2. The second price quotation, or the asked price, represents the lowest price at which a dealer is willing to sell the government security. Annual Reports (p. 380) • • • As pointed out earlier in this chapter, bondholders must be concerned about the financial health of the corporation or government unit that issues bonds. The information contained in a firm’s annual report is a logical starting point when evaluating the financial health of a corporation. Today, there are three ways to obtain a corporation’s annual report. 1. You can write or telephone the corporation and request an annual report. 2. Most corporations maintain an Internet Web page that contains detailed information about its financial performance. 3. Some financial publications provide a reader’s service that allows investors to use a toll-free telephone number or a postcard to obtain an annual report. • Regardless of how you obtain an annual report, you should look for signs of financial strength or weakness. The Internet (p. 380) • By accessing a corporation’s Web page and locating the topics “financial information,” “annual report,” or “investor relations,” you can find many of the answers relating to the financial strength of a company. • When investing in bonds, you can use the Internet in three other ways. You can 1. Obtain price information. 2. Trade bonds online. 3. Research a corporation by accessing bond Web sites. Bond Ratings (p. 380) • To determine the quality and risk associated with bond issues, investors rely on the bond ratings provided by the CBRS and DBRS. • As illustrated in Exhibit 12-7, bond ratings generally range from AAA (the highest) to D (the lowest). • Generally, Canadian government securities are not graded because they are risk free for practical purposes. Bond Yield Calculations (p. 382) • Two methods are used to measure the yield on a bond investment. 1. The current yield is determined by dividing the annual interest amount of a bond by its current market value. 2. The yield to maturity is a yield calculation that takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. Other Sources of Information (p. 384) • Investors can use two additional sources of information to evaluate potential bond investments. 1. Business periodicals and publications can provide information about the economy and interest rates and detailed financial information about a corporation or government entity that issues bonds. 2. A number of federal agencies provide information that may be useful to bond investors. . • Text Highlight: You may want to spend some time with the material in Exhibit 12-6 (p. 379) at this point in your lecture. • Text Highlight: You may want to review the boxed feature entitled “The Times Interest Earned Ratio.” • Text Highlight: You may want to review the “Financial Planning Calculations” boxed insert entitled “Evaluating Corporate Bonds” while discussing this section. • Concept Check 12-5 (p. 385) CONCLUDING ACTIVITIES • Point out the chapter summary (p. 385) and key terms in the text margin. • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, and Life Situation Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 12 QUIZ ANSWERS True-False 1. F 2. T 3. T 4. T 5. F 6. F 7. F 8. T Multiple Choice 9. A 10. D 11. B 12. A 13. D 14. A 15. D 16. B Name ________________________________________ Date____________________________ CHAPTER 12 QUIZ TRUE-FALSE _____1. _____2. A bond debenture is a legal document that details all of the conditions relating to a bond issue. Corporations sell corporate bonds to help finance their ongoing business activities. _____3. A mortgage bond is sometimes referred to as a secured bond. _____4. _____6. A sinking fund is a fund to which deposits are made each year for the purpose of redeeming a bond issue. If a bond is paying 8 percent interest when market rates are 9 percent, it must be trading at a premium. A Eurobond is denominated in euros only. _____7. Bondholder do not consider annual reports of the issuing company as relevant. _____8. Treasury bills are currently auctioned on a bi-weekly basis. _____5. MULTIPLE CHOICE _____9. A government security issued in minimum units of $1,000 with maturities that are 3 months, 6 months, and 12 months is called a a. Treasury bill. b. Treasury note. c. Treasury bond. d. Municipal bond. _____10. A bond that provides tax-free interest income is called a a. Corporate debenture bond. b. Corporate indenture bond. c. T-bill. d. None of the above. _____11. The current yield for a bond a. Is stated on the bond certificate. b. Is determined by dividing the dollar amount of annual interest by its current market price. c. Is not a factor when evaluating a bond investment. d. Takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. _____12. Which of the following statements is not true? a. A bearer bond bears the investor’s name. b. Bonds may be purchased in either the primary or secondary market. c. The usual face value of a bond is $1,000. d. A zero-coupon bond is also known a strip bond. _____13. A bond that is sold at a price far below its face, makes no interest payments, and is redeemed for its face value at maturity is called a ____________ bond. a. registered b. coupon c. indenture d. zero-coupon _____14. A(n) is a bond of a single issue that has multiple maturity dates. a. Serial bond b. Registered bond c. Bearer bond d. Zero-coupon bond _____15. The ___________ is a financially independent firm that acts as the bondholders' representative. a. Indenture b. Debenture c. Sinking fund d. Trustee _____16. ___________are Government of Canada bonds that pay you a rate of return that is adjusted for inflation. a. Registered bonds b. Real return bonds c. Treasury bonds d. Municipal bonds SUPPLEMENTARY LECTURE The information in this supplemental lecture can be used to reinforce the material in the sections entitled “A Typical Bond Transaction,” “Bond Ratings,” and “How to Read the Bond Section of the Newspaper.” Introduction Recently, a number of corporations have sold bonds to provide debt financing for expansion, research and development, debt retirement, or just about any other reason. From the investor’s standpoint, these new bond issues range from very conservative to very speculative investments. One Possible Bond Investment A Canadian company issues a bond with a face value of $1,000 with a maturity date of 2015. The interest rate is 8.38 percent. The DBRS rating for the bond is AAA. Activities You may want to use the following either as a class activity or as an outside assignment. All questions and activities are designed to enhance the material in Chapter 12. Questions 1. How important is a AAA DBRS? 2. What does the AAA rating mean? 3. The market value for this bond was $1,020 in May 2005. What is the current value of this bond? 4. Based on your answer to question number three, would this have been a good investment? ANSWERS TO CONCEPT QUESTIONS, OPENING CASE QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, AND LIFE SITUATION CASE CONCEPT QUESTIONS Concept Check 12-1 (p. 366) 1. If you needed information about a bond issue, would you go to the library or use the Internet? While students’ answers may vary, more and more people are using the Internet. For bonds, the Internet may be the most accessible source of up-to-date information. 2. What is the usual face value for a corporate bond? The usual face value of a corporate bond is $1,000, although the face value of some corporate bonds may be as high as $50,000. (p. 364) 3. What is the annual interest amount for a $1,000 bond issued by Power Corporation that pays 6½ percent interest? The annual interest is $65 as illustrated below. (p. 364) $1,000 × 0.065 = $65 Annual Interest 4. In your own words, define maturity date and bond indenture. The maturity date for a corporate bond is the date on which the corporation is to repay the borrowed money. A bond indenture is a legal document that details all of the conditions relating to a bond issue. (p. 366) 5. How does a trustee evaluate the provisions contained in a bond indenture? A trustee is a financially independent firm or individual that acts as the bondholders’ representative. Usually, the corporation must report to the trustee periodically regarding its ability to make interest payments and eventually redeem the bonds. In turn, the trustee transmits this information to the bondholders along with its own evaluation of the corporation’s ability to pay. If the corporation fails to live up to all the provisions contained in the indenture agreement, the trustee may bring legal action to protect the bondholders’ interest. (p. 366) Concept Check 12-2 (p. 369) 1. Why do corporations sell bonds? Corporations sell corporate bonds to help finance their ongoing business activities. They usually sell bonds when it is difficult or impossible to sell stock or preferred stock. (p. 366) 2. What are the differences between a debenture, a mortgage bond, and a subordinated debenture? A debenture is a bond that is backed only by the reputation of the issuing corporation. A mortgage bond is a corporate bond that is secured by various assets of the issuing firm. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to both income and assets. (p. 367) 3. Why would investors be attracted to bonds issued with warrants attached? A warrant gives the bondholder the right to purchase the firm’s common shares at a predetermined price. (p. 367) 4. Why would an investor purchase a convertible bond? A convertible bond gives the investor the right to exchange a convertible bond for a specified number of shares of the corporation’s common stock. It allows investors to enjoy the lower risk of a corporate bond and also take advantage of the speculative nature of common stock. (p. 367) 5. Describe three reasons a corporation would sell convertible bonds. The corporation gains three advantages by issuing convertible bonds. First, the interest rate on a convertible bond is often lower than that on traditional bonds. Second, the conversion feature attracts investors who are interested in the speculative gain that conversion to common stock may provide. Third, if the bondholder converts to common stock, the corporation no longer has to redeem the bond at maturity. (p. 366) 6. Explain the methods that corporations can use to repay a bond issue. A corporation may use one of two methods to ensure that it has sufficient funds available to redeem a bond issue. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. A corporation can also issue serial bonds. Serial bonds are bonds of a single issue that mature on different dates. (p. 368) Concept Check 12-3 (p. 374) 1. Describe the three reasons why investors purchase bonds. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. (p. 370) 2. What are the differences between a registered bond, a registered coupon bond, a bearer bond, and a zero-coupon bond? A registered bond is registered in the owner’s name by the issuing company. A registered coupon bond is issued with detachable coupons that the bondholder must present to a paying agent or the issuer to receive interest payments. A bearer bond is a bond that is not registered in the investor’s name. A zero-coupon bond is sold at a price far below its face value, makes no annual or semiannual interest payments, and is redeemed for its face value at maturity. (pp. 370-374) 3. In what ways can interest rates in the economy affect the price of a corporate bond? Changes in overall interest rates in the economy are an example of the concept of interest rate risk discussed in Chapter 10. If overall interest rates fall, then a corporate bond with a fixed interest rate will go up in value because of the bond’s higher interest rate. On the other hand, if overall interest rates rise, the market value of a corporate bond with a fixed interest rate will go down because of the bond’s lower interest rate. (p. 371) 4. Why is the value of a bond closely tied to the issuing corporation’s ability to repay its bond indebtedness? You should always remember that the value of a bond is tied to the ability of the corporation to repay the bond at maturity or make interest payments until maturity. If the corporation that issued the bond does incur financial problems, the value of a bond will go down. (pp. 371-372) 5. How are corporate bonds bought and sold? The bond market is referred to as an “OTC” exchange and is regulated by the Investment Dealers Association of Canada. Buyers and sellers trade bonds through bond or investment dealers. There are about 190 dealers and a smaller number of banks and trust companies involved in this market, and all of the dealers are linked together by five inter-dealer bond brokers. (pp. 373-374) Concept Check 12-4 (p. 378) 1. What are the maturities for the different government securities? Marketable bonds have a specific maturity date. Treasury bills are issued with maturities of 3, 6, or 12 months. CSBs are issued with a maturity of one year, on November 1st of each year. (p. 375) 2. How is the interest for Canada Savings Bonds calculated? CSB’s are available as either a regular interest bond or a compound interest bond. The regular interest bond pays annual interest on bonds held longer than three months. The compound interest bond allows you to forfeit receipt of annual interest to allow the unpaid interest to compound annually and earn interest on the accumulated interest. (p. 376) 3. What are the risks involved when investing in municipal bonds? Although municipal bonds are relatively safe, they are not backed by any assets, but rather by the municipality’s credit worthiness. Although the risk of default is minimal, when compared to government and provincial bonds, municipal bondholders should be concerned about continued interest payments and eventual repayment. (p. 378) Concept Check 12-5 (p. 385) 1. What is the market value for a bond with a face value of $1,000 and a newspaper quotation of 77.25 The market value for the above bond is $772.50 as illustrated below. $1,000 × .7725 = $772.50 market value 2. What type of information is contained in a corporation’s annual report? On a corporation’s Web site How could this information be used to evaluate a bond issue? Information about the firm’s finances is contained in its annual report. In most cases, there will be general and financial information on the firm’s Web page. Regardless of which source is used, an investor should find the answers to the following questions: (1) Is the firm profitable? (2) Are sales revenues increasing? (3) Are the firm’s long-term liabilities increasing? In fact, there are many questions that bondholders should ask before making a decision to buy a bond. (p. 380) 3. How important are bond ratings when evaluating a bond issue? To determine the quality and risk associated with bond issues, investors rely on the bond ratings provided by DBRS and Standard & Poor’s. Both rank thousands of corporate and municipal bonds. Although bond ratings may be flawed or inaccurate, most investors regard the work of both services as highly reliable. (p. 382) 4. Why should you calculate the current yield and yield to maturity on a bond investment? Yield calculations allow investors to compare bond investments with the yields of other investment alternatives, which include certificates of deposit, common stock, preferred stocks, and mutual funds. Naturally, the higher the yield, the better. (p. 382) 5. How can business periodicals and government publications help you evaluate a bond issue? Both business periodicals and government publications provide more information that may be needed to evaluate a bond investment. (p. 383) OPENING CASE QUESTIONS p. 363 1. What might make a particular investment, such as utility bonds, a good investment for one person and a poor one for another person? Bell bonds may be a good investment for an investor looking for a conservative investment that provides a predictable source of income. If an investor were looking for a more growth-oriented investment (like stocks or selected mutual funds), utility bonds might not be the type of investment that should be chosen. 2. Bethan Jackson divided her $22,000 nest egg between bonds and a GIC. Would you have made the same decision? While answers will vary, dividing her money between bonds and a GIC does provide some diversification. 3. Based on what you’ve learned so far, would you buy bonds issued by utilities such as this one? Explain your answer. Jackson did do some research before buying utility bonds. Still, students might want to do more research before deciding if they would buy these bonds. FINANCIAL PLANNING PROBLEMS p. 387 1. What is the annual interest amount for a $1,000 bond that pays 7 3/4 percent interest? The annual interest amount is $77.50 ($1,000 × 0.0775 = $77.50). 2. Dorothy Martin wants to invest $10,000 in corporate bonds. Her account executive suggested that she consider debentures, mortgage bonds, and convertible bonds. Since she has never invested in bonds, she is not quite sure how these bonds differ. How would you explain their differences to her? A debenture is a bond that is backed only by the reputation of the issuing corporation. A mortgage bond (sometimes referred to as a secured bond) is a corporate bond that is secured by various assets of the issuing firm. A convertible bond is a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. 3. List the reasons investors might want to buy zero-coupon bonds. Then list the reasons investors might want to avoid zero-coupon bonds. Based on these lists, do you consider zero-coupon bonds a good alternative for your investment program? Why or why not? A zero-coupon bond is sold at a price far below its face value, makes no annual or semiannual interest payments, and is redeemed for its face value at maturity. An investor who wants dollar appreciation over a long period of time should purchase a zero-coupon bond. Before investing in zero-coupon bonds, an investor should consider at least two factors. First, even though all of the interest on these bonds is paid at maturity, zero-coupon bondholders are required to report interest each year—as it is earned and not when it is actually received. Second, zero-coupon bonds are more volatile than other types of bonds. Student answers for the last part of this question will vary depending on each individual investor’s financial goals. 4. In your own words, explain how each of the following factors is a reason to invest in bonds. a. b. c. Interest income Interest income is a primary reason why investors choose to invest in either corporate or government bonds. Interest is calculated on the face value of the bond and is usually paid every six months. Possible increase in value Generally, bonds are issued with a stated face value. Once issued, the price may be higher or lower than its face value. Financial returns for comparable investments and interest rates in the economy are two factors that may cause the market value of a bond to increase or decrease. Repayment at maturity Whenever you purchase a bond, you have two options: you may keep the bond until maturity and then redeem it, or you may sell the bond at any time to another investor. In either case, the value of your bond is closely tied to the corporation’s ability to repay its bond indebtedness. 5. Complete the following table: Treasury bill CSB Minimum Amount _______________ _______________ Maturity Range _______________ _______________ How Interest is Paid _______________ _______________ Treasury bills, sometimes called T-bills, are issued in minimum units of $1,000 with additional increments of $1,000 and maturities that are 3 months, 6 months, or 12 months. T-bills are discounted securities, which means that these securities are sold at less than face value. At maturity, the owner of the bond receives the face value. There are two types of Canada Savings Bonds. The regular interest bond is available in denominations of $300, $500, $1,000, $5,000, and $10,000. Interest is paid only on bonds held longer than three months from the date of issue. This type of CSB pays annual interest on November 1st of each year. The compound interest bond is available in denominations of $100, $300, $500, $1,000, $5,000, and $10,000. This bond allows you to forfeit receipt of annual interest to allow the unpaid interest to compound annually and earn interest on the accumulated interest. CSBs can be cashed in by the owner at any bank in Canada, at any time. 6 Use the information provided by a newspaper like the Globe and Mail to answer questions about the following bond issues: Manulife Financial and Power Corporation. a. What is the ticker symbol for each bond issue? b. Determine the current yield for each bond issue. What does the current yield calculation measure? c. Determine the yield to maturity for each bond issue. What does the yield to maturity calculation measure? d. Based on your answer to the above questions, which bond would you choose for your investment portfolio? Explain your answer. e. Using the information on Standard & Poor’s Web site, determine the current yield for each bond issue. What does the current yield calculation measure? f. Using the information on Standard & Poor’s Web site, determine the yield to maturity for each bond issue. What does the yield to maturity calculation measure? g. What are the Standard & Poor’s ratings for each bond? What do these ratings mean? h. On the basis of your answer to the above questions, which bond would you choose for your investment portfolio? Explain your answer. Although answers to the above questions will vary, you may want to review the process used to evaluate a bond issue. 7. Choose a corporate bond listed in the Financial Post and use your online resources to answer the following questions on this bond issue. a. b. c. d. e. f. What is the DBRS rating for the issue? What is the purpose of the issue? Does the issue have a call provision? Who is the trustee for the issue? What collateral, if any, has been pledged as security for the issue? Based on the information you have obtained, would the bond be a good investment for you? Why or why not? The answers for each of the above questions will depend on the bond that each student chooses. An alternative approach may be to require all students to research the same bond. 8. Assume you purchased a corporate bond at its current market price of $850 on January 1, 2005. It pays 9 percent interest and it will mature on December 31, 2014, at which time the corporation will pay you the face value of $1,000. a. Determine the current yield on your bond investment at the time of purchase. The current yield = interest income ÷ current market value The current yield = $90 divided by $850 = 10.6 percent b. Determine the expected yield to maturity on your bond investment at time of purchase. Face Value - Market Value Number of Periods The yield to maturity = Market Value + Face Value 2 $1,000 − 850 $90 + 10 Yield to maturity = $850 + 1,000 2 Yield to maturity = 11.4 percent Interest amount + 9. Referring to the bond described in Problem 8, assume that the bond’s interest payments were reinvested at a rate of 5% per annum. a. What would be the future value of the reinvested coupons (there are 10 years of coupons received between 2005 and 2014). The future value of reinvested interest would be: 2nd CLRTVM 90 PMT 10 N 5 I COMP FV 1,132 At maturity, the total value of the reinvested interest added to the face value would equal $1,000 + $1,132 = $2,132. b. Given the purchase price of $850, the maturity value of $1,000 added to the future value of the reinvested coupons, what was the bond’s average annual compound return? The bond’s annual realized yield would be: CLRTVM 2nd 850 +/PV 2,132 FV 10 N COMP I 9.63% c. Repeat this calculation assuming bond interest was reinvested at 15% per annum. What was the bond’s average annual compound return? The future value of reinvested interest would be: CLRTVM 2nd 90 PMT 10 N 15 I COMP FV 1,827 At maturity, the total value of the reinvested interest added to the face value would equal $1,000 + $1,827 = $2,827. The bond’s annual realized yield would be: 2nd 850 +/2,827 10 COMP I CLRTVM PV FV N 12.77% d. What do you conclude from these two calculations? The bond’s original term to maturity was 11.4%. However, this assumes all interest will be reinvested at this rate. If interest is reinvested at a lower rate, the annual realized yield will be less than the expected yield to maturity. If interest is reinvested at a rate higher than 11.4%, the annual realized yield will exceed the expected YTM. FINANCIAL PLANNING ACTIVITIES p. 388 1. Prepare a one-minute oral presentation that describes the type of information contained in a bond indenture. The bond indenture is the legal document that details all of the conditions relating to a bond issue. Often comprising over 100 pages of complicated wording, the bond indenture remains in effect until the bonds reach maturity or are redeemed by the corporation. 2. Locate an advertisement for a new bond issue in The Globe and Mail, The Financial Post, or a local newspaper. Then go to the library or use the Internet to research the corporation or government entity that is issuing the bonds. Based on your research, prepare a two-page report on the issuer. Be sure to describe its financial condition and how the money raised by selling bonds will be used. Student answers will vary, but you may want to review the material on why corporations sell bonds. You may also want to review the “Meditrust” advertisement. 3. Talk to an account executive about the differences among debentures, mortgage bonds, and subordinated debentures. Describe your findings. A debenture is a bond that is backed only by the reputation of the issuing corporation. A mortgage bond, sometimes referred to as a secured bond, is a corporate bond that is secured by various assets of the issuing firm. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to both income and assets. 4. Assume that you just inherited ten Westcoast Energy Inc. bonds, and each bond is convertible to 64.5 shares of the corporation’s common stock. a. What type of information would you want to help you decide whether to convert your bonds to common stock? Most investors would begin their search for information about this Westinghouse bond with information contained in the newspaper. Then a trip to the library could provide more detailed information about the bond and the company. While at the library, investors could examine Moody’s Industrial Manuals for detailed information about the information contained in the bond indenture. They could also find information about the company. Some of the same type of information is also available on the Internet. b. Where would you obtain this information? Most investors could obtain this information by making a trip to the library. Investors could also write or call Westinghouse and request an annual report which would provide detailed financial information about the company and its ability to pay interest until maturity and its ability to repay the bond at maturity. It would also be possible to obtain much of this same financial information about Westinghouse by accessing the Internet. c. Under what conditions would you convert your bonds to common stock? The most obvious answer is when the stock is worth more than the bond. But this question is difficult to answer because if the market value of the common stock increases, the market value of the bond also increases. d. Under what conditions would you keep the bonds? Often the market value of the common stock will “push” the value of the bond higher. As a result, many investors would prefer to keep their bonds because of more secure interest payments and eventual repayment at maturity. 5. Survey at least two investors that own either corporate or government bonds. Then answer the following questions. a. b. c. d. Why did these investors purchase the bonds? How long have they invested in bonds? Do they consider their bond issues conservative or speculative investments? Why did they decide to purchase bonds instead of other investments like certificates of deposit, stocks, mutual funds, or real estate? a. Although answers will vary, most investors purchase corporate or government bonds because they feel these investments are more secure because interest must be paid until maturity and eventual repayment at maturity. b. Answers will vary. c. Most investors consider corporate and government bonds a conservative investment. (Note: You may want to remind students that some bonds may be considered speculative investments because of the corporation or government entity that issued them.) d. Most investors would indicate an improved total return on their bond investment when compared to other conservative investments. 6. Using information from the local newspaper or The Financial Post, answer the following questions on the bond issues listed below. Newspaper _________________ Date ______________ Current Yield Volume Close Price AirCa 6.750 __________ _______ _________ BCE 6.2 __________ _______ _________ Molson 5.4 __________ _______ _________ The answers for this question will depend on the source of the information and the date of the publication. An alternative approach would be to require all students to use the same publication on the same date. 7. In your own words, describe what affects the current yield and the yield to maturity for a bond. In both cases, the biggest factor that influences the current yield and the yield to maturity is the current market value of the bond. In addition, the yield to maturity is affected by the number of periods until maturity. Most all other factors stay the same regardless of when the calculations are calculated. 8. Choose a corporate bond that you would consider purchasing. Then, using information obtained in the library or on the Internet, answer the questions on the evaluation form that was presented in the “Financial Planning Calculations” boxed feature on page 373. Based on your research, would you still purchase this bond? Explain your answer. Answers will vary depending on the bond that students choose and the source of the information used for evaluation purposes. LIFE SITUATION CASE A Lesson from the Past (p. 390) 1. According to Mary Goldberg, the chance to invest in New World Explorations was “too good to pass up.” Unfortunately, it was too good to be true, and she lost $10,000. Why do you think so many people are taken by get-rich-quick schemes? For most people, the lure of “big” profits encourages them to invest without thinking. At this point, you may want to remind students of the old adage, “If it’s too good to be true, it probably is.” 2. During the last part of the l990s, investors were forced to look for ways to squeeze additional income from their investment portfolios. Do you think investing in corporate bonds or quality stocks is the best way to increase income? Why or why not? Although answers will vary, stocks, bonds, and mutual funds were popular investments during the last part of the l990s. In fact, one of several reasons the experts give to explain the growth of the TSE 300 and the Dow Jones during this period were the number of people taking money from banks, savings and loans, and other financial institutions and investing in the stock market either directly by purchasing individual stocks or indirectly by purchasing mutual funds. Solution Manual for Personal Finance Jack Kapoor, Les Dlabay, Robert J. Hughes, Arshad Ahmad 9780071320597, 9781259453144