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Chapter 12 Investing in Stocks and Bonds How Will This Affect Me? Once you’ve figured out how much you need to invest to meet important financial goals, it’s time to decide which specific investments to buy. This chapter describes the basic characteristics of stocks and bonds, explains their potential returns and risks, and provides a framework for choosing among stocks and bonds to meet your financial objectives. Care is taken to explore how stock and bond prices behave and how to evaluate their performance over time. After reading this chapter you should be able to choose the most appropriate stocks and bonds for your portfolio in light of your goals and constraints. You will need to spend some time with this chapter. If you assign and go over several of the homework problems, it will take 4 or 5 50-minutes classes. As I said at the beginning of Chapter 11, this is important material and is worth the time. The material in this chapter is best learned in a hands-on exercise. As suggested in Chapter 11, some investing game would help make the concepts here real. Perhaps the game could be played over a longer period as part of an investment club. Perhaps prizes could be awarded for the best performance. Maybe even a scholarship for next semester or graduate study could be offered. Alumni could be involved by meeting with the students occasionally to comment on what they are doing. If not the above, assign the Financial Planning Exercises which ask the student to make investment decisions. Learning Objectives 12-1 Describe the various types of risks to which investors are exposed, as well as the sources of return. The goal here is learning terminology and understanding the trade-offs. Power points will be sufficient. 12-2 Know how to search for an acceptable investment on the basis of risk, total return, and yield. Learning the discipline of computing the various statistics and writing down the alternatives will help the student in the long run. Insisting on written comparisons in the homework will go a long way in achieve this. Exhibit 12.2 is worth spending time in class. 12-3 Discuss the merits of investing in common stock and be able to distinguish among the different types of stocks. As you go through the types of stocks, giving examples of companies that match the stock type will help make real to students. 12-4 Become familiar with the various measures of performance and how to use them in placing a value on stocks. The financial planning exercises give opportunities for the student to compute these measures as well as read reports that give these measures for the company being reported. Use them. 12-5 Describe the basic issue characteristics of bonds, as well as how these securities are used as investment vehicles. If the students have had principle of accounting, they should be familiar with terms concerning investment in bonds. The focus here in on terminology. 12-6 Distinguish between the different types of bonds, gain an understanding of how bond prices behave, and know how to compute different measures of yield. The financial planning exercises give opportunities for the student to compute the yields and I suggest that you assign them. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • You would have to save $2,500 a year in order to end up with a $25,000 nest egg in ten years. Fantasy: Each year you will earn interest on the previous amounts saved. Therefor if you invest $2,500 per year, in ten years you will have more than $25,000. At a 5% rate, you will have $31,445. • A good investment is one that offers a positive rate of return. Fantasy: A good investment is one that offers an expected return that equals or exceeds the investor’s required rate of return, which is defined relative to the risk of the investment. Thus, what might be a good return in one case may be totally inadequate in another. • Income stocks have relatively high dividend yields and, as such, appeal to individuals who seek a high level of current income. Fact: Income shares are have a long and sustained record of regularly paying a much higher than average level of dividends. Because of this, they are highly sought after by investors seeking a safe and steady source of current income. • Putting your money into stocks that offer dividend reinvestment plans is a great way of building up your investment capital. Fact: In a dividend reinvestment plan, you receive additional shares of stock, rather than cash every time the company pays a dividend. It’s a great way to reap the benefits of compounding and watch your money grow over time. • When interest rates go down, bond prices also go down because such securities become less valuable. Fantasy: Bond prices and interest rates move in the opposite direction. As a result, when interest rates go down, bond prices go up. • Convertible bonds are so named because they can be exchanged for a set number of shares of common stock. Fact: Convertible bonds carry the provision that they may, within a stipulated time period, be converted into a certain number of shares of the issuing company’s common stock. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False You would have to save $2,500 a year in order to end up with a $25,000 nest egg in ten years. 2. True False A good investment is one that offers a positive rate of return. 3. True False Income stocks have relatively high dividend yields and, as such, appeal to individuals who seek a high level of current income. 4. True False Putting your money into stocks that offer dividend reinvestment plans is a great way of building up your investment capital. 5. True False When interest rates go down, bond prices also go down because such securities become less valuable. 6. True False Convertible bonds are so named because they can be exchanged for a set number of shares of common stock. Answers: 1. False 2. False 3. True 4. True 5. False 6. True YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. YOU CAN DO IT NOW What’s the Market P/E Ratio Telling You? Nobel Prize-winning Professor Robert Shiller came up with the Shiller P/E ratio, which is based on average inflation-adjusted price multiples over ten year intervals. Many use it to get a sense of whether the overall stock market is properly valued. You can check out the current Shiller P/E ratio vs. historical averages for the U.S. and several other major stock markets at the interesting Research Affiliates site: https://www.researchaffiliates.com/AssetAllocation/Pages/Equities.aspx. You can do it now. YOU CAN DO IT NOW What’s the Market P/E Ratio Telling You? Nobel Prize-winning Professor Robert Shiller came up with the Shiller P/E ratio, which is based on average inflation-adjusted price multiples over ten year intervals. Many use it to get a sense of whether the overall stock market is properly valued. You can check out the current Shiller P/E ratio vs. historical averages for the U.S. and several other major stock markets at the interesting Research Affiliates site: https://www.researchaffiliates.com/AssetAllocation/Pages/Equities.aspx. You can do it now. YOU CAN DO IT NOW How Do Stock and Bond Market Returns Compare This Year? If you want a broad sense of how stock and bond returns compare so far this year, take a look at the returns on two broad-based exchange traded funds (ETFs, which we discuss in detail in chapter 13). Vanguard’s Total Stock Market ETF (ticker VTI) seeks to track the overall performance of U.S. stocks traded on the New York Stock Exchange and NASDAQ. And Vanguard’s Total Bond Market ETF (ticker BND) seeks to track investment grade U.S. bonds. Take a look at the YTD returns, which were, for example, 2.29 percent for VTI and 1.29 percent for BND on May 21, 2015. Just go to http://finance.yahoo.com/ and type VTI and then BND into the Quote Lookup box. You can do it now. How Do Stock and Bond Market Returns Compare This Year? If you want a broad sense of how stock and bond returns compare so far this year, take a look at the returns on two broad-based exchange traded funds (ETFs, which we discuss in detail in chapter 13). Vanguard’s Total Stock Market ETF (ticker VTI) seeks to track the overall performance of U.S. stocks traded on the New York Stock Exchange and NASDAQ. And Vanguard’s Total Bond Market ETF (ticker BND) seeks to track investment grade U.S. bonds. Take a look at the YTD returns, which were, for example, 2.29 percent for VTI and 1.29 percent for BND on May 21, 2015. Just go to http://finance.yahoo.com/ and type VTI and then BND into the Quote Lookup box. You can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. Lucy and Ted Like High Flying Stocks Lucy and Ted Richardson are both 33 years old and invest 15 percent of their after-tax annual income in stocks. They hate missing out on great returns when the stock of a company doing great things starts going through the roof. For example, Lucy and Ted feel they should have invested in Activision Blizzard in 2017 when it earned almost an 80 percent return! So any time a company they know well earns more than 20 percent in a year, they try to invest in it. And because they believe in the stocks they buy, the Richardsons always hold their stocks until they at least break even. What do you make of the Richardsons’ approach to stock investing? The Richardsons’ decision to invest 15 percent of their after-tax income is great. However, Lucy and Ted shouldn’t invest just in stocks and should adopt an asset allocation strategy that provides diversified exposure to bonds, real estate, and more. Their current exclusive focus on stocks is likely too risky. Further, their rule to buy well-known stocks that earn more than a 20 percent return in a year likely leaves them insufficiently diversified. And their 20 percent return rule also focuses too much on past returns and not enough on a careful forecast of future returns. The Richardsons could end up with overvalued stocks with their best performance behind them. Finally, their rule to not sell until they at least break even suggests the behavioral bias of unduly “anchoring” on purchase prices. It could be that a company has changed for the worse and it’s simply time to sell, even if it implies a loss. Investing 15 percent of their income is great, but the Richardsons could do even better. Financial Planning Exercises 1. Ranking investments by expected returns. What makes for a good investment? Use the approximate yield formula or a financial calculator to rank the following investments according to their expected returns. a. Buy a stock for $30 a share, hold it for three years, and then sell it for $60 a share (the stock pays annual dividends of $2 a share). b. Buy a security for $40, hold it for two years, and then sell it for $100 (current income on this security is zero). Approximate yield = (0 + [(100 – 40)/2] ) / (40 + 100)/2 = 30/70 = 43% c. Buy a one-year, 5 percent note for $1,000 (assume that the note has a $1,000 par value and that it will be held to maturity). Approximate yield = (50 + [(1,000 – 1,000)/1] ) / (1,000 + 1,000)/2 = 50/1,000 = 5% Ranking: b is 1st; a is 2nd, and c 3rd. 2. Calculating expected return on investment. An investor is thinking about buying some shares of Health Diagnostics, Inc., at $75 a share. She expects the price of the stock to rise to $115 a share over the next three years. During that time, she also expects to receive annual dividends of $4 per share. Assuming that the investor’s expectations (about the future price of the stock and the dividends it pays) hold up, what rate of return can the investor expect to earn on this investment? (Hint: Use either the approximate yield formula or a financial calculator to solve this problem.) See complete formula in answer 1a above. Approximate yield = (4 + [(115 – 75)/3] ) / (75 + 115)/2 = 17.33 / 95 = 18.2% 3. Calculating expected return on a stock. The price of Outdoor Designs, Inc. is now $85. The company pays no dividends. Fred Gray expects the price four years from now to be $125 a share. Should Fred buy Outdoor Designs if he wants a 15 percent rate of return? Explain. Approximate yield = (0 + [(125 – 85)/4] ) / (85 + 125)/2 = 10 / 105 = 9.5% No, this stock does not meet the required return of 15%. Using the financial calculator set on 1 P/YR and End Mode: 4. Calculating key stock performance metrics. The Castle Company recently reported net profits after taxes of $15.8 million. It has 2.5 million shares of common stock outstanding and pays preferred dividends of $1 million a year. The company’s stock currently trades at $60 per share. a. Compute the stock’s EPS. EPS = (after tax income – preferred stock dividend) / shares O/S = (15.8 – 1) / 2.5 = $5.92 per share b. What is the stock’s P/E ratio? Price/earnings = $60 / 5.92 = 10.1 c. Determine what the stock’s dividend yield would be if it paid $1.75 per share to common stockholders. Dividend yield is dividend / price = 1.75 / 60 = 2.9% 5. Choosing appropriate stocks. Assume that you’ve just inherited $500,000 and have decided to invest a big chunk of it ($350,000, to be exact) in common stocks. Your objective is to build up as much capital as you can over the next 15 to 20 years, and you’re willing to tolerate a “good deal’’ of risk. a. What types of stocks (blue chips, income stocks, and so on) do you think you’d be most interested in, and why? Select at least three types of stocks and briefly explain the rationale for selecting each. Mid-caps, growth stocks, b. Would your selections change if you were dealing with a smaller amount of money—say, only $50,000? What if you were a more risk-averse investor? Investing $350,000 with High Risk Tolerance 1. Sector Allocation : 40% Technology : Invest in high-growth companies like Apple, Microsoft, Amazon. 20% Healthcare/Biotech : Focus on innovative firms such as Moderna, Pfizer. 20% Green Energy : Companies like Tesla, NextEra Energy. 20% Emerging Markets : ETFs/stocks in economies like China (Alibaba), India. 2. Stock Selection Strategy : Mix of Individual Stocks and ETFs : Combine sector-specific ETFs (e.g., QQQ, IBB, ICLN, EEM) with carefully chosen high-growth stocks for diversification. Investing $50,000 with High Risk Tolerance 1. Sector Allocation with ETFs : 50% Technology ETF (e.g., QQQ) 20% Healthcare/Biotech ETF (e.g., IBB) 15% Green Energy ETF (e.g., ICLN) 15% Emerging Markets ETF (e.g., EEM) 2. Stock Selection Strategy : Use ETFs for Diversification : Focus on ETFs to spread risk across multiple high-growth sectors. Investing $350,000 with Risk Aversion 1. Diversified Portfolio : 40% Blue-Chip Stocks : Stable companies like Johnson & Johnson, Procter & Gamble. 30% Dividend-Paying Stocks : Reliable dividend stocks like AT&T, Verizon. 20% Bonds and Fixed Income : US Treasury bonds, high-quality corporate bonds. 10% REITs : Real estate investments for income stability. 2. Stock and Bond Selection Strategy : Focus on Stability and Income : Invest in blue-chip and dividend-paying stocks, supplemented with bonds for security. Investing $50,000 with Risk Aversion 1. Balanced Portfolio : 30% Blue-Chip Stocks ETF (e.g., SPY) 30% Dividend-Paying Stocks ETF (e.g., VIG) 20% Bonds and Fixed Income ETF (e.g., BND) 10% REITs ETF (e.g., VNQ) 10% Cash or Money Market Funds 2. Stock and Bond Selection Strategy : ETFs for Diversification and Stability : Use ETFs to achieve a balanced portfolio focusing on stability and income. Summary High Risk Tolerance ($350,000) : Mix of high-growth sectors and individual stocks/ETFs. High Risk Tolerance ($50,000) : Focus on sector-specific ETFs for diversification. Risk Aversion ($350,000) : Diversified portfolio with blue-chip stocks, dividend payers, bonds, and REITs. Risk Aversion ($50,000) : Balanced ETFs focusing on stability and income. 6. Calculating and interpreting current yield and yield to maturity. Find the current yield of a 5.65 percent, 8-year bond that’s currently priced in the market at $853.75. Now, use a financial calculator to find the yield to maturity on this bond (use annual compounding). What’s the current yield and yield to maturity on this bond if it trades at $1,000? If it’s priced at $750? Comment on your findings.
Quote Current Yield Yield to Maturity Using Financial Calculator
5.65%, 8 yr., $853.75 $56.5/$853.75 = 6.62%% 853.75 +/- PV 1000 FV 56.5/2 PMT 8 × 2 N CPT I/Y 4.09% * 2 = 8.18%
5.65%,8yr, $1,000 $56.5 / $1,000 = 5.65% 1000 +/- PV 1000 FV 56.5/2 PMT 8 × 2 N CPT I/Y 2.83% * 2 = 5.66%
5.65%, 8 yr., $750 $56.5 / 750 = 7.53% 750 +/- PV 1000 FV 56.5/2 PMT 8 × 2 N CPT I/Y 5.16% * 2 = 10.32%
Investopedia has a yield to maturity calculator at https://www.investopedia.com/calculator/aoytm.aspxhttps://www.investopedia.com/calculator/aoytm.aspx. It is simple to use. 7. Tax treatment of bond returns. An investor in the 22 percent tax bracket is trying to decide which of two bonds to select: one is a 5.5 percent U.S. Treasury bond selling at par; the other is a municipal bond with a 4.25 percent coupon, which is also selling at par. Which of these two bonds should the investor select? Why? After federal tax US Treasury bond is 5.5% * (1 - .22) = 4.29% Municipal bond after federal tax is 4.25%, it is not subject to federal income tax. In this case, the return on the Treasury bond is slightly higher, and it is more secure than a municipal bond. If you add state income tax, it becomes more complicated. Most states do not tax interest from bonds issues by the same state. But they may tax interest on bonds issued by other states. Most states do not tax interest on federal debt issues, bonds or notes. So above, if the municipal bond is issued by a different state, the treasury debt is even more attractive. Also note that if the federal tax rate is the next higher bracket, 24%, the municipal bonds have a higher after-tax return. 8. Calculating current yield and yield to maturity. Describe and differentiate between a bond’s (a) current yield and (b) yield to maturity. Why are these yield measures important to the bond investor? Find the yield to maturity of a 20-year, 9 percent, $1,000 par value bond trading at a price of $850. What’s the current yield on this bond? a. The current yield is found by dividing the annual interest income by the market price of the bond. It is basically the same figure as the dividend yield on a stock, and it would be important to investors seeking current income. b. The yield to maturity is the annual rate of return a bondholder would receive if he or she held the bond to its maturity. This yield is approximated by adding the annual income to the average capital gain over the life of the bond and dividing this by the average amount invested in the bond. Thus, whereas current yield involves only interest income, yield to maturity considers both interest income and capital gains. These yield measures are important to bondholders because they are used to assess the underlying attractiveness of a bond investment. If a bond provided a yield to maturity that equaled or exceeded the desired return on a bond, it would be an attractive investment. Using the approximate yield = (90 + [(1000 – 850)/20] ) / (850 + 1000)/2 = 97.5/925 = 10.5% When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year.
Quote Current Yield Yield to Maturity Using Financial Calculator
9%, 20 yr., $850 $90/$850 = 10.6% 850 +/- PV 1000 FV 90/2 PMT 20 × 2 N CPT I/Y 5.426 × 2 = 10.85%
9. Calculating and comparing current yields. Which of these two bonds offers the highest current yield? Which one has the highest yield to maturity? a. A 6.55 percent, 22-year bond quoted at 52.000 Approximate yield = (65.5 + [(1000 – 520)/22] ) / (520 + 1000)/2 = 87.3/760 = 11.5% Investopedia calculator computes an annual return to maturity of 13.42% b. A 10.25 percent, 27-year bond quoted at 103.625 Approximate yield = (102.5 + [(1000 – 1036.25)/27] ) / (1036.25 + 1000)/2 = 101.2 / 1018.25 = 9.9% Investopedia calculator computes an annual return to maturity of 9.86%. The 6.55 percent bond has a deep discount price. It results in the higher yield. 10. Clean and dirty bond prices. You have decided to sell a 5 percent semiannual coupon bond two months after the last coupon payment. The bond is currently selling for $951.25. Answer the following questions about the bond: a. What is the clean price of the bond? Clean price is without adding accrued interest, that is the quoted price of $951.25. b. What is the dirty (full) price of the bond? The dirty (full) price of the bond adds the accrued interest. Interest of $25 is paid each six months. The time is two months after the last coupon date; therefore the accrued interest is 2/6 * $25, or $8.33. The dirty price is the quoted price plus accrued interest, $951.25 + $8.33 = $959.58. c. Explain how the clean and dirty prices of the bond are relevant to the buyer of the bond. Interest is earned with the passing of time. The seller is going to want their earned interest when the bond is sold, therefore the buyer is going to pay for some of the interest that he/she received at the coupon date. The accrued interest in included in the price of the bond. The buyer would want to know that. Test Yourself 12-1 Describe the various types of risk to which investors are exposed. 1. Business risk is the variability surrounding the firm’s cash flows and subsequent ability to meet operating expenses on time. 2. Financial risk concerns the amount of debt used to finance a firm, as well as the possibility that the firm will not have sufficient cash flows to meet these obligations on time. 3. Market risk results from the behavior of investors in the securities markets that can lead to swings in security prices. 4. Changes in the general level of prices within the economy also produce purchasing power risk. 5. Fixed-income securities—which include notes, bonds, and preferred stocks—offer investors a fixed periodic cash flow and, as such, are most affected by interest rate risk. As interest rates change, the prices of these securities fluctuate, decreasing with rising interest rates and increasing with falling rates. 6. The risk of not being able to liquidate (i.e., sell) an investment conveniently and at a reasonable price is called liquidity risk. 7. Event risk occurs when something substantial happens to a company and that event, in itself, has a sudden impact on the company’s financial condition. 12-2 What is meant by the risk-return trade-off? What is the risk-free rate of return? The amount of risk associated with a given investment vehicle is directly related to its expected return. This universal rule of investing means that if you want a higher level of return, you’ll probably have to accept greater exposure to risk. This is the risk-return trade-off. Note that it’s possible to receive a positive return for zero risk, such as at point A. This is referred to as the risk-free rate of return, which is often measured by the return on a short-term government security, such as a 90-day Treasury bill (T-bill). 12-3 Briefly describe the two basic sources of return to investors. Any investment vehicle—whether it’s a share of stock, a bond, a piece of real estate, or a mutual fund—has just two basic sources of return: current income and capital gains. Current income is generally received with some degree of regularity over the course of the year. It may take the form of dividends on stock, interest from bonds, or rents from real estate. The other type of return available from investments is capital appreciation (or growth), which is reflected as an increase in the market value of an investment vehicle. Capital gains occur when you’re able to sell a security for more than you paid for it or when your security holdings go up in value. 12-4 What is interest on interest, and why is it such an important element of return? Note that because the bond was originally bought at par ($1,000), you start off with a 4 percent investment. Where you end up depends, in large part, on what you do with the interest earnings from this investment. If you don’t reinvest the interest income at the original 4 percent, then you could end up at the 3 percent line—or even lower. You have to earn interest on interest from your investments in order to move to the 4 percent line. 12-5 What is the desired rate of return, and how would it be used to make an investment decision? The value of any investment depends on the amount of return that it’s expected to provide relative to the amount of perceived risk involved. The minimum rate of return that you believe you should receive in compensation for the amount of risk that you must assume. An investment should be considered acceptable only if it’s expected to generate a rate of return that meets (or exceeds) your required or desired rate of return. 12-6 From a tax perspective, would it make any difference to an investor whether the return on a stock took the form of dividends or capital gains? Explain. Historically yes it mattered. However, for tax years beginning after 2012, qualified dividends [basically those from domestic corporations and qualified foreign corporations] are taxed at 20% if the regular tax rate is 39.6% or 15% if the tax rate is 25-35%. If the regular tax rate is 10 or 15%, qualified dividends and long-term capital gains are taxed a 0%. 12-7 What’s the difference between a cash dividend and a stock dividend? Which would you rather receive? Cash dividends are paid to the stockholder in cash and are taxable at the capital gains rate. Stock dividends paid to the shareholder in stock and are non-taxable. Stock dividends have no current value since they simply give the stockholder more shares, but the percent of ownership does not change. However, historically, the stock price has not adjusted completely for the stock dividend. Thus, the shareholder does receive a slight increase in value for the total shares owned after a stock dividend. Cash is always acceptable and most likely preferred. Receiving cash allows the shareholder to invest in other companies or if desired to purchase more of the same corporation stock. Or consume more. 12-8 Define and briefly discuss each of these common stock measures: (a) book value, (b) ROE, (c) EPS, (d) P/E ratio, and (e) beta. The amount of stockholders’ equity [assets minus liabilities minus preferred stock] in a firm is measured by book value. Book value indicates the amount of stockholder funds used to finance the firm. Return on equity (ROE) reflects the firm’s overall profitability from the equity holders’ perspective. It is computed as income divided by equity. Earnings per share (EPS) translates total corporate profits into profits on a per share basis and provides a convenient measure of the amount of earnings available to stockholders. It is computed as: EPS = (Net profit after taxes - Preferred dividends paid)/ Number of shares of common stock outstanding When the prevailing market price of a share of common stock is divided by the annual EPS, the result is the price/earnings (P/E) ratio, which is viewed as an indication of investor confidence and expectations. A stock’s beta is an indication of its price volatility; it shows how responsive the stock is to changes in the overall stock market. Low-beta stocks—those with betas of less than 1.0—have low price volatility (their prices are relatively stable), whereas high-beta stocks—those with betas of more than 1.0—are considered to be highly volatile. In short, the higher a stock’s beta, the riskier it’s considered to be. Most stock betas are positive, which means the stocks move in the same general direction as the market. 12-9 Briefly discuss some of the different types of common stock. Which types would be most appealing to you, and why? 1. blue-chip stock A stock generally issued by companies expected to provide an uninterrupted stream of dividends and good long-term growth prospects. 2. growth stock A stock whose earnings and market price have increased over time at a rate that is well above average. 3. Tech stocks represent the technology sector of the market and include all those companies that produce or provide technology-based products and services such as computers, semiconductors, data storage devices, computer software and hardware, peripherals, Internet services, content providers, networking, and wireless communications. 4. Stocks whose appeal is based primarily on the dividends they pay are known as income stocks. They have a fairly stable stream of earnings, a large portion of which is distributed in the form of dividends. 5. Investors in speculative stocks gamble that some new information, discovery, or production technique will favorably affect the firm’s growth and inflate its stock price. 6. Stocks whose price movements tend to follow the business cycle are called cyclical stocks. This means that when the economy is in an expansionary stage, the prices of cyclical stocks tend to increase; during a contractionary stage (recession), they decline. 7. In the stock market, a stock’s size is based on its market value—or, more commonly, on what’s known as its market capitalization or market cap. Large-cap refers to capitalization of more than $10 billion; mid-cap, from $2 to $10 billion; and small-cap, less than $2 billion. 12-10 Summarize the evidence on the potential cost of being out of the stock market during its best months. A common myth: During volatile markets, it makes sense to sell your stocks and wait for calmer conditions. While it sounds so reasonable, investors who remain in the market outperform those who move in and out to manage their market exposure. When trading in and out, you pay more commissions and, more important, you tend to miss the upturns in the market that can make you whole—or even more than whole—again. 12-11 What are DRPs, and how do they fit into a stock investment program? The investment philosophy at work with a dividend reinvestment plan (DRP) is this: if the company is good enough to invest in, then it’s good enough to reinvest in. In a DRP, shareholders can sign up to have their cash dividends automatically reinvested in additional shares of the company’s common stock 12-12 Go to the asset allocation tool provided at the following internet site: http://www.ipers.org/calcs/AssetAllocator.html. Enter assumptions that fit your current and anticipated situation and produce an asset allocation recommendation. Then add 20 years to your age and redo the calculations. Finally, redo the calculations assuming minimal risk tolerance. Explain the results of changing these key assumptions. I inserted the age of 20, current assets $100,000, savings per year $5,000, tax rate 28%, 0% income and risk tolerance of 5. The suggested allocation was 91% stocks, 4% bonds, and 5% cash. I changed the age to 40, kept all other the same. The suggested allocation was 71% stocks, 12% bonds, and 17% cash. The suggested allocation became more conservative with higher bonds and cash. However, the suggested stock was still high, 71%. The software considers age “. . . by far the most important aspect of asset allocation.” 12-13 What’s the difference between a secured bond and an unsecured bond? Secured bonds have specific assets as collateral for the bond. In effect, it is like a mortgage. Unsecured bonds do not have any specific assets pledged to support the bond and as such are like any other open account liability. The bonds will have priority over equities in case of a liquidation in bankruptcy. 12-14 Are junk bonds and zero coupon bonds the same? Explain. What are the basic tax features of a tax-exempt municipal bond? Zero coupon bonds, as the name implies, are bonds issued without coupons. To compensate for their lack of coupons, these bonds are sold at a deep discount from their par values and then increase in value over time, at a compound rate of return, so at maturity they’re worth much more than their initial investment. Other things being equal, the cheaper the bond, the greater the return you can earn. Junk bonds are rated by the rating agencies in the lowest category. These ratings indicate that, although the principal and interest payments on the bonds are still being met, the risk of default is relatively high because the issuers lack the financial strength found with investment-grade issues. Municipal bonds are issued by a state or a political division of a state. The interest on the bonds are exempt from federal income tax, but any gain from holding the bonds will be taxable. Thus, for a high bracket taxpayer, the tax saving will increase the return making the bond preferable over other bonds with lower returns. 12-15 What is a convertible bond, and why do investors buy convertible securities? The convertible bond, found only in the corporate market, is a type of hybrid security because they possess the features of both corporate bonds and common stocks. That is, though they’re initially issued as debentures (unsecured debt), they carry a provision that enables them to be converted into a certain number of shares of the issuing company’s common stock. With convertible bonds, the investor can hedge their bet. If the corporation does well and the common stock increases in value, the bonds may be converted. If things are not so good, the convertible bonds will be held as bonds and receive interest according to the provisions of the bond. 12-16 Describe the conversion privilege on a convertible security. Explain how the market price of the underlying common stock affects the market price of a convertible bond. The key element of any convertible issue is its conversion privilege, which describes the conditions and specific nature of the conversion feature. First, it states exactly when the bond can be converted. Sometimes there’ll be an initial waiting period of six months to perhaps two years after the date of issue, during which time the issue cannot be converted. The conversion period then begins, after which the issue can be converted at any time. From the investor’s point of view, the most important feature is the conversion ratio, which specifies the number of shares of common stock into which the bond can be converted. For example, one of these bonds might carry a conversion ratio of 20, meaning that you can exchange one convertible bond for 20 shares of the company’s stock. Convertibles seldom trade precisely at their conversion value; instead, they usually trade at conversion premiums, which means that the convertibles are priced in the market at more than their conversion values. 12-17 Explain the system of bond ratings used by Moody’s and Standard & Poor’s. Why would it make sense to ever buy junk bonds? Bond ratings are like grades: A letter grade is assigned to a bond, which designates its investment quality. Ratings are widely used and are an important part of the municipal and corporate bond markets. Exhibit 12.7 lists the rating levels by Moody and Standard & Poor. The top Moody rating is Aaa while the top S&P rating is AAA. The ratings go down from there. Junk bonds are more risky than AAA bonds. In order to sell the bonds they may have a higher rate or a conversion privilege that makes the risk worthwhile. 12-18 Explain the difference between dirty (full) and clean bond prices? What is the significance of the difference in the prices for a bond buyer? In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction between clean prices and dirty (full) prices. Clean prices do not include accrued interest while dirty prices are the quoted price of the bond plus any accrued interest. 12-19 What effects do market interest rates have on the price behavior of outstanding bonds? If the market price goes up, the bond value goes down. The interest that will be paid is set by the terms of the bond, thus, a change in the market rate does not change the amount of interest that will be paid. The only way to adjust to the market rate is to adjust the price of the bond. Criterial Thinking Cases 12.1 The Madsen’s Problem: What to Do with All That Money? A couple in their early 30s, Rodney and Carly Madsen recently inherited $90,000 from a relative. Charles earns a comfortable income as a sales manager for System Analytics, Inc., and Carly does equally well as an attorney with a major law firm. Because they have no children and don’t need the money, they’ve decided to invest all of the inheritance in stocks, bonds, and perhaps even some money market instruments. However, because they’re not very familiar with the market, they turn to you for help. Critical Thinking Questions 1. What kind of investment approach do you think the Madsen should adopt—that is, should they be conservative with their money or aggressive? Explain. The Madsens do not have a specific goal that they are investing to reach. Also, they do not appear to want to spend time managing the investments. They also only have $90,000 so a wide array of stock portfolio is not feasible. While it is the topic of chapter 13, I would suggest two mutual funds, one growth orientated and one income fund. Over the long-run, they can expect to see their investment grow at about 8% per year and they will have little work to do. If they want to spend some time investing the funds, they can select three so stocks and buy and hold with occasionally [at least quarterly] checking their status. 2. What kind of stocks do you think the Madsen should invest in? How important is current income (i.e., dividends or interest income) to them? Should they be putting any of their money into bonds? Explain. As above, if they invest in stocks, I would suggest some utility stock and health care stock. Bonds with only $90,000 is not for me, but is a possibility. 3. Construct an investment portfolio that you feel would be right for the Madsen and invest the full $90,000. Put actual stocks, bonds, and/or convertible securities in the portfolio; you may also put up to one-third of the money into short-term securities such as CDs, Treasury bills, money funds, or MMDAs. Select any securities you want, so long as you feel they’d be suitable for the Madsen. Make sure that the portfolio consists of six or more different securities, and use the latest issue of The Wall Street Journal or an online source such as http://finance.yahoo.com to determine the market prices of the securities you select. Show the amount invested in each security along with the amount of current income (from dividends and/or interest) that will be generated from the investments. Briefly explain why you selected these particular securities for the Madsen’ portfolio. The students like many investors, will most likely look at the past returns and assume they will continue in the future. It would be great if the students could have the opportunity to invest part of the school’s endowment funds so that could get some real experience over a couple of years. If not that, perhaps an investment club could be formed and give prizes for high performance over two semesters. As for the Madsens, what I said in part 1 goes. 12.2 Natasha Explores Investing Natasha Cormier is a 28-year-old management trainee at a large chemical company. She is single, has an annual salary of $34,000 (placing her in the 15 percent tax bracket), and her monthly expenditures come to approximately $1,500. During the past year or so, Natasha has managed to save around $8,000, and she expects to continue saving at least that amount each year for the foreseeable future. Her company pays the premium on her $35,000 life insurance policy. Because Natasha’s entire education was financed by scholarships, she was able to save money from the summer and part-time jobs she held as a student. Altogether, she has a nest egg of nearly $18,000, out of which she’d like to invest about $15,000. She’ll keep the remaining $3,000 in a bank CD that pays 3 percent interest and will use this money only in an emergency. Natasha can afford to take more risks than someone with family obligations can, but she doesn’t wish to be a speculator; she simply wants to earn an attractive rate of return on her investments. Critical Thinking Questions 1. What investment options are open to Natasha? Growth stocks, small caps, and perhaps tech stocks are the type of securities that fits her financial goals. It would be to her advantage to invest in a retirement fund that allows her to defer taxes until the money is withdrawn. 2. What chance does she have of earning a satisfactory return if she invests her $15,000 in (a) bluechip stocks, (b) growth stocks, (c) speculative stocks, (d) corporate bonds, or (e) municipal bonds? a. Bluechips have been around for a long time and may be expected to follow the general market. Accordingly, she can expect about 8% over long term in a slow and steady progression. b. Growth stocks is like “those men in their flying machines”, they will go up and they will go down. If they are in one of the up cycles at time of sale, the return may be better than the market as a whole. c. Speculative stocks are not for an investor with only $15,000. The chance of loss is too great for that amount. Leave those for the Trumps of the world. d. Corporate bonds will yield a slow and steady return, likely just below the stock market as a whole. Appreciation is not likely with bonds. e. Municipal bonds are advantageous to taxpayers in the highest bracket. She is not there yet so there is no reason for her to invest in these bonds. 3. Discuss the factors you would consider when analyzing these alternate investment vehicles. The driving force is her risk tolerance. Stocks are volatile, that is their price will go up and down, sometimes way down only to come way up later. Also, the time she will spend managing the portfolio is a factor. You have to pay attention to your investments. 4. What recommendation would you make to Natasha regarding her available investment alternatives? Explain. As in part 1, I would urge her to put money in a retirement fund and invest in growth stock and smallcap stock. Both of these have potential for appreciation. With her low tax rate [15%] long-term gains will be taxed at 0 for federal income tax but taxed at the state level the same as her salary. So taxes are not really an issue for her. She is seeking appreciation, not income. Terms Found in the Chapter
accrued interest The amount of interest that’s been earned since the last coupon payment date by the bond holder/seller, but which will be received by the new owner/buyer of the bond at the next regularly scheduled coupon payment date.
agency bond An obligation of a political subdivision of the U.S. government.
beta . An index of the price volatility for a share of common stock; a reflection of how the stock price responds to market forces.
blue-chip stock A stock generally issued by companies expected to provide an uninterrupted stream of dividends and good long-term growth prospects.
book value The amount of stockholders’ equity in a firm; determined by subtracting the company’s liabilities and preferred stock from its assets.
business risk The variability associated with a firm’s cash flows and with its subsequent ability to meet its operating expenses on time.
call feature Bond feature that allows the issuer to retire the security prior to maturity.
clean price The quoted price of a bond, which understates the true price of a bond by any accrued interest.
conversion premium The difference between a convertible security’s market price and its conversion value.
conversion privilege The provision in a convertible issue that stipulates the conditions of the conversion feature, such as the conversion period and conversion ratio.
conversion ratio A ratio specifying the number of shares of common stock into which a convertible bond can be converted.
conversion value A measure of what a convertible issue would trade for if it were priced to sell based on its stock value.
corporate bond A bond issued by a corporation.
coupon Bond feature that defines the annual interest income the issuer will pay the bondholder.
current yield . The amount of current income a bond provides relative to its market price.
cyclical stock Stock whose price movements tend to parallel the various stages of the business cycle.
debenture An unsecured bond issued on the general credit of the firm.
defensive stock Stock whose price movements are usually contrary to movements in the business cycle.
discount bond A bond whose market value is lower than par.
dirty (full) price The quoted price of a bond plus accrued interest, the total of which is the relevant price to be paid by a bond buyer.
dividend reinvestment plan (DRP) A program whereby stockholders can choose to take their cash dividends in the form of more shares of the company’s stock.
dividend yield The percentage return provided by the dividends paid on common stock.
earnings per share (EPS) The return earned by each share of common stock; calculated by dividing all earnings remaining after paying preferred dividends by the number of common shares outstanding.
equipment trust certificate A bond secured by certain types of equipment, such as railroad cars and airplanes.
event risk The risk that some major, unexpected event will occur that leads to a sudden and substantial change in the value of an investment.
financial risk A type of risk associated with the amount of debt used to finance the firm and its ability to meet these obligations on time.
fixed-income securities Securities such as bonds, notes, and preferred stocks that offer purchasers fixed periodic income
fully taxable equivalent yield The return that a fully taxable bond must provide in order to match the after-tax return on a lower-yielding tax-free bond.
general obligation bond A municipal bond backed by the full faith and credit of the issuing municipality.
growth stock A stock whose earnings and market price have increased over time at a rate that is well above average.
junk bond Also known as high-yield bonds, these are highly speculative securities that have received low ratings from Moody’s or Standard & Poor’s.
income stock A stock whose appeal is the dividends it pays out; offers dividend payments that can be expected to increase over time.
interest rate risk A type of risk, resulting from changing market interest rates, that mainly affects fixed-income securities.
large-cap stock A stock with a total market value of more than $10 billion.
liquidity risk A type of risk associated with the inability to liquidate an investment conveniently and at a reasonable price.
market risk A type of risk associated with the price volatility of a security.
mid-cap stock A stock whose total market value falls somewhere between $2 billion and $10 billion.
mortgage-backed securities Securities that are a claim on the cash flows generated by mortgage loans; bonds backed by mortgages as collateral.
municipal bond A bond issued by state or local governments; interest income is usually exempt from federal taxes.
mortgage bond A bond secured by a claim on real assets, such as a manufacturing plant.
net profit margin A key measure of profitability that relates a firm’s net profits to its sales; shows the rate of return the company is earning on its sales.
premium bond A bond whose market value is higher than par.
price/earnings (P/E) ratio A measure of investors’ confidence in a given security; calculated by dividing market price per share by EPS.
proxy A written statement used to assign a stockholder’s voting rights to another person, typically one of the directors.
purchasing power risk A type of risk, resulting from possible changes in price levels, that can significantly affect investment returns.
residual owners Shareholders of the company; they are entitled to dividend income and a share of the company’s profits only after all of the firm’s other obligations have been met.
return on equity (ROE) A measure that captures the firm’s overall profitability; it is important because of its impact on the firm’s growth, profits, and dividends.
required rate of return The minimum rate of return an investor feels should be earned in compensation for the amount
revenue bond . A municipal bond serviced from the income generated by a specific project
risk-free rate of return The rate of return on short-term government securities, such as Treasury bills, that is free from any type of risk.
serial obligation An issue that is broken down into a series of smaller bonds, each with its own maturity date and coupon rate.
sinking fund A bond provision specifying the annual repayment schedule to be used in paying off the issue.
small- cap stock A stock with a total market value of less than $2 billion.
speculative stock Stock that is purchased on little more than the hope that its price per share will increase.
stock dividends New shares of stock distributed to existing stockholders as a supplement to or substitute for cash dividends.
tech stock A stock that represents the technology sector of the market.
Treasury bond A bond issued and backed up by the full faith and credit of the U.S. government.
Treasury inflation- indexed bond A bond, issued by the U.S. government, whose principal payments are adjusted to provide protection again inflation as measured by the Consumer Price Index (CPI).
yield to maturity The fully compounded rate of return that a bond would yield if it were held to maturity.
zero coupon bond A bond that pays no annual interest but sells at a deep discount to its par value.
Investing in Stocks and Bonds Chapter Outline Learning Objectives I. The Risks and Rewards of Investing A. The Risks of Investing 1. Business Risk 2. Financial Risk 3. Market Risk 4. Purchasing Power Risk 5. Interest Rate Risk 6. Liquidity Risk 7. Event Risk B. The Returns from Investing 1. Current Income 2. Capital Gains 3. Earning Interest on Interest: Another Source of Return C. The Risk-Return Trade-off D. What Makes a Good Investment? 1. Future Return 2. Approximate Yield II. Investing in Common Stock A. Common Stocks as a Form of Investing 1. Issuers of Common Stock 2. Voting Rights 3. Basic Tax Considerations B. Dividends C. Some Key Measures of Performance 1. Book Value 2. Net Profit Margin 3. Return on Equity 4. Earnings per Share 5. Price/Earnings Ratio 6. Beta D. Types of Common Stock 1. Blue-Chip Stocks 2. Growth Stocks 3. Tech Stocks 4. Income Stocks versus Speculative Stocks 5. Cyclical Stocks or Defensive Stocks 6. Large-Caps, Mid-Caps, and Small-Caps E. Market Globalization and Foreign Stocks F. Investing in Common Stock 1. Advantages and Disadvantages of Stock Ownership G. Making the Investment Decision 1. Putting a Value on Stock 2. Timing Your Investments 3. Be Sure to Plow Back Your Earnings III. Investing in Bonds A. Why Invest in Bonds? B. Bonds versus Stocks C, Basic Issue Characteristics 1. Types of Issues 2. Sinking Fund 3. Call Feature D. The Bond Market 1. Treasury Bonds 2. Agency and Mortgage-Backed Bonds 3. Municipal Bonds 4. Corporate Bonds 5. The Special Appeal of Zero Coupon Bonds 6. Convertible Bonds E. Bond Ratings Exhibit 12.6 F. Pricing a Bond 1. Bond Prices and Accrued Interest 2. Bond Prices and Yields 3. Current Yield and Yield to Maturity Financial Impact of Personal Choices: Lucy and Ted Richardson Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
