Chapter 12 Investing in Stocks and Bonds Chapter Outline Learning Goals I. The Risks and Rewards of Investing A. The Risks of Investing 1. Business Risk 2. Financial Risk 3. Market Risk 4. Purchasing Power Risk 5. Interest Rate Risk 6. Liquidity Risk 7. Event Risk B. The Returns from Investing 1. Current Income 2. Capital Gains 3. Earning Interest on Interest: Another Source of Return C. The Risk-Return Trade-off D. What Makes a Good Investment? 1. Future Return 2. Approximate Yield *Concept Check* 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 *Concept Check* 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 F. Pricing a Bond 1. Bond Prices and Accrued Interest 2. Bond Prices and Yields 3. Current Yield and Yield to Maturity *Concept Check* Summary Financial Planning Exercises Applying Personal Finance What's Your Type? Critical Thinking Cases 12.1 The Ashcrofts’ Problem: What to Do with All That Money? 12.2 Elaine Decides to Try Her Hand at Investing Money Online! Major Topics The financial rewards from investing can be great. However, investors first need to understand the features of the various types of investments and the risks inherent in each. The major topics in this chapter include: 1. The risks associated with investing include business risk, financial risk, market risk, interest rate risk, purchasing power risk, liquidity risk and event risk. 2. Interest-on-interest underlies all elements of total return and is the basic assumption in estimations of future return. 3. The risk-return trade-off is an important element of investing. 4. Common stock is a rewarding type of investment security. 5. The valuation of common stock provides a means of specifying the risks and rewards associated with common stock investing. 6. Bond investing provides current income from interest. Key Concepts In studying investments, one must understand the jargon of the investment world. This chapter explains basic investment terminology and explores the features of the various types of investments. Key concepts in this chapter include the following: 1. The risks of investing 2. Investment returns 3. Interest on interest 4. The risk-return trade-off 5. Measures of return 6. Common stocks 7. Rights of common stockholders 8. Dividends 9. Measures of stock performance 10. Common stock valuation 11. Types of common stock 12. Foreign securities and ADRs (American Depositary Receipts) 13. Bonds 14. Bond issue characteristics 15. Types of bonds 16. Bond ratings 17. Bond prices and yields 18. Inverse relationship between interest rates and bond prices 19. Zero coupon bonds 20. Convertible bonds 21. Residual owners 22. Dividend yield 23. Stock dividends 24. Book value 25. Net profit margin 26. Return on equity (ROE) 27. Earnings per share (EPS) 28. Price/earnings ratio (P/E) 29. Beta 30. Blue-chip stock 31. Growth stock 32. Tech stock 33. Income stock 34. Speculative stock 35. Cyclical stock 36. Defensive stock 37. Large-cap stock 38. Mid-cap stock 39. Small-cap stock 40. Mortgage-backed securities 41. Equipment trust certificate 42. Debenture 43. Sinking fund 37. Call feature 48. Treasury bond 49. Treasury inflation-indexed bond (TIPS) 50. Agency Bond 51. Municipal Bond 52. Serial obligation 53. Revenue bond 54. General obligation bond 55. Corporate bond 56. Junk bond Answers to Concept Check Questions 12-1 Investors are exposed to business risk, the possibility that the firm will fail, due to factors affecting the firm, such as economic or industry factors or poor management decisions. Business risk may be thought of as the degree of uncertainty associated with the firm's earnings and consequent ability to pay dividends and interest. There is financial risk, which is the risk associated with the mix of debt and equity financing used by the issuing company. Too much debt could also lead to financial failure. Market risk is reflected in the price volatility of a security and is associated with factors such as changes in political, economic, and social conditions and in investor tastes and preferences. Purchasing power risk is the risk resulting from possible changes in price levels that can have a significant effect on investment returns. In times of rising prices, the purchasing power of the dollar declines. Interest rate risk results from changing market interest rates that mainly affect fixed-income securities. The prices of these securities decrease with rising interest rates and increase with falling rates. Liquidity risk is associated with the inability to liquidate an investment conveniently and at a reasonable price. Finally, there is event risk, which is the risk that something totally unexpected will happen (like a corporate takeover) to cause the market price of a security to drop dramatically. 12-2 The risk-return trade-off refers to the universal rule of investing that the amount of risk associated with an investment is directly related to the expected return of the investment. If you want a higher return, you must be willing and able to accept a higher level of risk. The risk-free rate of return is the positive level of return that you can earn even though there is virtually no risk of default involved in the security. This rate is usually identified as the return on short-term government securities, such as Treasury bills. (Even though this is referred to as the “risk-free” rate, bear in mind that these low rates of safe return are very susceptible to purchasing power risk—the risk that the growth in the value of the investment will not keep pace with inflation. In addition, if these investments are held outside a tax-sheltered environment, they are also subject to taxes.) 12-3. The two basic sources of return are current income and capital gains. Current income is the amount of return generated annually from an investment and takes the form of dividends, interest, or rent. A capital gain, in contrast, reflects the price behavior of an investment over time and is captured through capital appreciation (or loss). 12-4. Interest-on-interest is one of the most important, yet most overlooked, sources of return. Interest-on-interest means keeping your capital fully invested—it means reinvesting the current income and realized capital gains into other investment products. It is through interest-on-interest that we are able to earn fully compounded rates of return (over the long haul) on our investments. Indeed, over extended (lengthy) periods of time, interest-on-interest may account for as much as 40–60% of total return. 12-5. An investor's desired rate of return is the minimum rate of return acceptable for the amount of risk that the investor must bear. An investment should be considered acceptable only if it is expected to generate a rate of return that meets or exceeds the investor's desired rate of return. 12-6. Yes, tax-wise, it makes a difference to investors whether they receive a return on stocks in the form of dividends or capital gains. Short-term capital gains (gains on property held less than one year) are taxed as regular income to the taxpayer at rates which currently go up to over 30% (rates are scheduled to go down through time). Dividends and capital gains on property held longer than one year are taxed more favorably. For taxpayers in the 10% and 15% tax brackets, the rate is 5%. For taxpayers in brackets higher than 15%, the rate is 15%. Also, an even more favorable 5-year capital gains rate has recently come into effect. 12-7. Dividends can take two forms—cash dividends and stock dividends. Cash dividends are just what the name implies. The most common form of dividend, they are typically paid on a quarterly basis in cash. Stock dividends pay existing shareholders in new shares of stock. However, the shareholder's proportion of ownership and investment value remain the same. The price generally falls in direct proportion to the size of the stock dividend. Investors should prefer to receive cash dividends. Cash dividends provide additional return, while stock dividends do not represent additional value. When a company issues a stock dividend, the price of its shares falls accordingly, and each shareholder holds the same proportion of the company's total outstanding stock as before. 12-8. a. Book value represents the accounting value of a firm. The book value is determined by subtracting the firm's liabilities and preferred stock value from its assets. The resulting amount would be the book value of the common stock. b. Return on Equity (ROE) relates the amount of profits that the firm is generating relative to the firm's equity base, and it reflects the overall profitability of the firm. It captures the amount of success the firm is having in managing its assets, operations, and capital structure; ROE is important because of its impact on the profits, growth, and dividends of the firm. An increasing ROE is desirable, while a decreasing ROE is something the firm would probably rather avoid. c. Earnings per share (EPS) is the amount earned for each common share outstanding during a specific period of time. The EPS is determined by dividing all earnings after taxes and claims by preferred shareholders by the number of common shares outstanding. d. The price/earnings ratio (P/E) is calculated by dividing the price of the common stock by the earnings per share; it indicates how aggressively the stock is being priced relative to its earnings and reflects the level of investor confidence and expectations. e. Beta measures the market risk in a share of common stock; it reveals how the price of a stock behaves relative to the market (which has a beta of one). The larger the stock's beta, the more risky the investment. A stock with a beta of 1.7, for example, is considered to be more price volatile than one with a beta of 0.7. 12-9. Blue chip stocks are issued by the strongest, most stable companies and usually provide uninterrupted streams of dividends and strong long-term growth prospects. Growth stocks are expected to continue to experience consistently high rates of growth in operations and earnings. Both blue-chips and growth stocks have great appeal to investors with long-term investment objectives. Growth stocks offer better return at somewhat greater risk. Tech stocks are those of companies in the technology sector of the market. The technology sector has been a dominant sector in market growth during the past 10-15 years and is expected to remain fairly strong for the foreseeable future. Tech stocks usually fall into the growth or speculative category, although some are now in the blue-chip category. Income stocks are purchased primarily for the high current dividends they pay. An added feature of these stocks is that the amount of their dividends usually increases over time. They are attractive to investors who need current income and are less concerned about future growth in value or the higher taxation of dividends. Speculative stocks offer the investor an unusual opportunity for price appreciation based on some special situation that has occurred in the company. These securities are usually not attractive to conservative long-term investors. Stocks whose price movements follow the economy are cyclical stocks. They tend to have positive market risk and are best used by investors when the economy starts to recover from a recession. Defensive stocks are considered counter cyclical since they usually do not move with the economy. These are generally lower risk stocks. Both cyclical and defensive stocks can be used in a portfolio that contains other types of stocks. Their purpose would be to change the risk of the portfolio. Mid-cap and small-cap stocks are stocks of companies whose market capitalization falls under certain limits: about $4–5 billion for mid-caps and $1 billion for small caps. Mid-caps offer investors opportunities for capital appreciation and are an alternative to large stocks. Small caps, and even smaller micro caps, are riskier investments and require careful analysis. Student preferences among these stock types will vary, but point out that a diversified portfolio may well have some of each to provide long-term stability. 12-10. Research shows that most investors are better off investing steadily than trying to time the market. Because it is exceedingly difficult to buy consistently at market bottoms and sell at market tops, there is a high potential cost of being out of the equity market during its best-performing times. This is because pulling money out of the market exposes you to the significant risk that you’ll miss the months of good returns that could help you recoup prior losses. As the text indicated, ten good days out of the market could result in almost half the growth obtained by staying in the market. 12-11. In a dividend reinvestment plan shareholders can sign up to have their cash dividends automatically used to buy additional shares of the company's common stock. A major purpose of an investment program is to earn a fully compounded rate of return. This means keeping your money fully invested at all times, something that a dividend reinvestment plan allows you to do automatically. 12-12. Student answers will vary depending upon the assumptions entered. 12-13. A secured bond is one that is backed by a legal claim on some specific property of the issuer, which is called collateral. These are senior bonds. Examples of secured bonds are mortgages, which are secured by real property, and equipment trust certificates, which are backed by equipment and are used by airlines and railroads. Unsecured bonds, although they are still legally binding debt obligations of the company, are not backed by property. They are backed only by the promise of the issuer to pay interest and principal on a timely basis. These are junior bonds, and debentures are probably the most popular of such issues. 12-14. No, junk and zero-coupon bonds are not the same. Junk bonds pay a high coupon and offer a high yield because they are considered to be a riskier investment. They are issued by companies which have received below-investment grade ratings on their bond issues. On the other hand, zero coupon bonds do not pay a coupon. They are sold at a deep discount to par value and mature at par value. Some zero-coupon bonds are of very high quality and are particularly useful for investors who have a cash flow need at a certain target date. With no interest payments, investors do not have to worry about rates of return on reinvested interest payments. However, because there are no coupon payments, zeros experience greater price volatility when interest rates change, which can be of great concern to investors who sell zeros before maturity. Additionally, interest is “imputed” on zeros, and if they are held outside a tax-sheltered environment, investors must pay yearly income taxes on this imputed interest even though they have received no cash interest payments. Municipal bonds are issued by state and local governments and provide interest income to investors that is not subject to federal income tax (Note: while the interest income is tax exempt, capital gains are not). The 1986 Tax Reform Act changed the tax status of some municipal bonds. If the proceeds of the bond issue are used for nonessential purposes, the interest received is subject to federal income tax. Additionally, if you live in a state with a state income tax and buy municipal bonds from another state, that interest income will be subject to your state’s income tax. And finally, taxpayers subject to the alternative minimum tax may have to pay federal income taxes on income from municipal bonds, so yes, taxes may have to be paid on municipal bonds. 12-15. A convertible bond is a type of debenture bond that carries with it the provision that within a certain time period it may be exchanged into a certain number of shares of the issuing company's common stock. Investors buy convertible bonds because they offer the steady income of a debt security plus the promise of participation in the growth of the equity value of the company should the price of the company's stock appreciate above the conversion price of the bond. 12-16. The conversion privilege stipulates the nature of the conversion feature. It includes a statement about the conversion period during which the bond can be converted, and the conversion ratio, which specifies the number of shares of common stock into which the bond can be converted. It is the conversion ratio acting with the market price of the common stock that gives the bond its conversion value. The conversion value is the value at which the bond would trade if it were priced to sell on the basis of its stock value. It is found by multiplying the conversion ratio, or the number of shares of common stock one will get, by the market price of the common stock. Since the conversion ratio is usually fixed, the conversion value can only change if and when the market price of the common stock changes. Therefore, a rise in the market price of the convertible will depend on a rise in the market value of the common stock. 12-17. Moody's and Standard & Poor's each have their own system of rating bonds. Their ratings reflect the quality and degree of risk they perceive in the bond. (See Exhibit 12.7 in the text for the ratings and associated interpretations.) Every time a large, new issue comes to the market, it is analyzed by a staff of professional bond analysts to determine its default risk exposure and its investment quality. The rating given applies only to that particular bond issue, so that one company could have more than one issue of bonds outstanding, and each could have a different rating. The rating agencies also reexamine older bonds to see if their ratings need to be changed. 12-18. In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction between clean prices and dirty (full) prices. This can be concisely summarized as: Dirty (full) price = quoted price + accrued interest Clean price = quoted price So what's the significance of the distinction between dirty and clean prices for bond buyers? It's important to realize that the commonly-cited prices in the financial press and on the Web are most likely net of accrued interest and are so-called clean bond prices. The relevant sale or invoice price of a bond to the buyer is the dirty price, which adds the accrued interest to the quoted price. In terms of this problem, the buyer of the bond would pay the dirty price. In summary, the quoted clean price understates the true (dirty) price that must be paid to actually purchase the bond in the open market. 12-19. The higher the current market interest rate is relative to the stated interest rate on an outstanding bond, the lower the market price of the bond; in contrast, the lower the current market interest rate is relative to the bond's stated interest rate, the higher the market price of the bond. The current market interest rate viewed relative to the stated interest rate on a bond impacts the bond price in the marketplace. When the current market rate is higher than the stated rate, the bond sells at a discount. When the current market rate is below the stated (coupon) rate, the bond will sell at a premium. Current market rates, therefore, can have a profound effect on the prices of outstanding bonds. Financial Planning Exercises 1. A good investment is one that promises enough return to compensate the investor for the amount of risk involved; this basic risk-return rule applies to any type of investment vehicle. Investments should also be selected according to their appropriateness for the investor's objective (for example, current income or long-term growth), time horizon, and liquidity needs. Tax implications can also influence investment choices, particularly for investors in the higher tax brackets. Based on the above calculations, the investments would be ranked from highest to lowest expected return as b, a, then c; this assumes, of course, that there is equal risk exposure and identical tax implications in all three investments. 2. 3. a. While student answers will vary, given the parameters in the question (capital appreciation and above-average risk tolerance), most will probably focus on the following categories: Growth and Tech stocks: These stocks are expected to achieve high growth rates and are ideal for this portfolio because of their potential for large gains from price appreciation. Growth and tech stocks typically carry betas over 1.0, which is not a problem for a risk-taking investor. Speculative stocks: These would appeal to this investor as well. Unlike stocks with a proven record of earnings, these stocks are bought with the hope that prices will rise due to something new—products, information, research developments, etc. For example, stocks of biotech companies whose researchers are developing new treatments for cancer are speculative. Once they have a proven product, they may be considered growth stocks. Mid-cap stocks: Stocks with market capitalization under about $4–5 billion offer attractive return potential without the price fluctuations of speculative stocks. They would be a good balance to the riskier investments in the portfolio. Small-cap stocks: These stocks of companies with less than $1 billion in market capitalization offer high growth and return potential but with higher risk than midcaps. Point out that even a long-term growth portfolio should probably also contain some large blue-chip stocks, income stocks, bonds, and money market. Student answers will vary regarding their three stock selections and rationale. b. With a smaller amount to investment, students should include the more conservative categories—blue chip, defensive, income stocks, bonds and money market—in a greater proportion to provide a balance for higher risk holdings. A more risk averse investor might eliminate speculative stocks altogether and increase the amount of conservative securities. 4. Research shows that most investors are better off investing steadily than trying to time the market. Because it is exceedingly difficult to buy consistently at market bottoms and sell at market tops, there is a high potential cost of being out of the equity market during its best-performing times. This is because pulling money out of the market exposes you to the significant risk that you’ll miss the months of good returns that could help you recoup prior losses. As the text indicated, ten good days out of the market could result in almost half the growth obtained by staying in the market. 5. 6. 7. 8. Mr. Perth should not buy Garden Designs Inc. if he desires a 15% rate of return, as this stock's expected return will not be that high 9. To solve this problem, we must first find the taxable equivalent yield on the municipal bond and then compare that to the yield on the Treasury bond. The taxable equivalent yield for an investor in the 28% marginal tax bracket is: This calculation shows us that for an investor to be better off with the Treasury bond, this taxable investment must return greater than 5.9%. Such is not the case with the 5.5% T-bond. The investor would be better off with the municipal bond. However, since there is little risk of default on T-bonds, only highly rated municipal bonds should be compared to Treasury securities. 10. a. The current yield is found by dividing the annual interest income by the market price of the bond. It is basically the same figure as the dividend yield on a stock, and it would be important to investors seeking current income. b. The yield to maturity is the annual rate of return a bondholder would receive if he or she held the bond to its maturity. This yield is approximated by adding the annual income to the average capital gain over the life of the bond and dividing this by the average amount invested in the bond. Thus, whereas current yield involves only interest income, yield to maturity considers both interest income and capital gains. These yield measures are important to bondholders because they are used to assess the underlying attractiveness of a bond investment. If a bond provided a yield to maturity that equaled or exceeded the desired return on a bond, it would be an attractive investment. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. 11. Calculations for the two bonds follow. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. 12. Calculations for the 3 bond quotes follow. 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 a. 5.65%, 8 yr., $853.75 $56.50/$853.75 = 6.62% 853.75 +/- PV 1000 FV 56.50/2 PMT 8 × 2 N CPT I/Y 4.09 × 2 = 8.18% b. 5.65%, 8 yr., $1,000 $56.50/$1,000 = 5.65% 1000 +/- PV 1000 FV 56.50/2 PMT 8 × 2 N CPT I/Y 2.825 × 2 = 5.65% c. 5.65%, 8 yr., $750 $56.50/$750 = 7.53% 750 +/- PV 1000 FV 56.50/2 PMT 8 × 2 N CPT I/Y 5.16 × 2 = 10.32% When a bond is trading at par value, its current yield and yield to maturity will be equal. When it is trading at a premium, its yield to maturity will be less than its current yield because the investor is paying more than par for the bond. When the bond is trading at a discount, its yield to maturity will be greater than its current yield because the investor paid less than par value for the bond. Both the first and third quotes are discounted bonds. 13. A zero coupon bond by definition pays no coupon or yearly interest, so investors profit only from the capital gains. Zero coupon bonds are purchased at a deep discount and pay the investor par value at maturity. Investors discount $1,000 back to the present using the going interest rate to determine how much they would be willing to pay today to purchase the bond. If the bond quote is 6.50, investors are willing to pay 6.50% of par or 0.065 × $1,000 = $65 per bond. Current yield = annual interest/current market price = 0 [Zeros pay no annual interest] 14. a. A 7.5% coupon bond will pay 0.075 × $1,000 par value or $75 in interest per year. Current yield when purchased = Annual interest/Current market price = $75/$850 = 0.088 = 8.8%. Current yield one year later = $75/$962.50 = 0.0779 = 7.79%. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. 15. If the bond is selling for $1,500, the conversion premium would be the difference between the price of the bond and its conversion value. In this case, the conversion premium is $180 ($1,500 – $1,320). 16. Convertible bond: $1,000 face value, 6% coupon, 20-year maturity, convertible into 25 shares; current price of the convertible is $800; current stock price is $35; current yearly dividend is $0.95/share. When using the financial calculator, set on 1 payment per year, End Mode, and assume that interest payments are made twice a year. 17. This library problem is designed to provide hands-on experience to the student, and as such any specific solution is not possible here. 18. In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction between clean prices and dirty (full) prices. This can be concisely summarized as: Dirty (full) price = quoted price + accrued interest Clean price = quoted price (a) The clean price would be: 951.25 (b) The dirty price would be: 951.25 + [(50/2) × (2/6)] = $959.58 (c) So what's the significance of the distinction between dirty and clean prices for bond investors? It's important to realize that the commonly-cited prices in the financial press and on the Web are most likely net of accrued interest and are so-called clean bond prices. The relevant sale or invoice price of a bond to the buyer is the dirty price, which adds the accrued interest to the quoted price. In terms of this problem, the buyer of the bond would pay the dirty price. In summary, the quoted clean price understates the true (dirty) price that must be paid to actually purchase the bond in the open market. Solutions to Critical Thinking Cases 12.1 The Ashcrofts’ Problem: What to Do with All That Money? 1. The Ashcrofts have a comfortable income, no children, and no special goal for this money. They should take a long-term investment approach and can afford to be fairly aggressive in their choice of investments, depending on their tolerance for risk. 2. In selecting stocks for their portfolio, the Ashcrofts would want a fair amount of blue-chip stocks with also some growth and defensive stocks to round out their holdings. Many blue-chip companies pay dividends, so some amount of income stocks would be included already in their blue chips. Their selection of growth stocks will probably include some tech stocks, and they can choose several from the mid-cap and small-cap range in order to balance out their portfolio. Defensive stocks provide some amount of downside protection in the event of an economic downturn. If the economic outlook is positive, the Ashcrofts also might want to include some cyclical stocks in their portfolio. The Ashcrofts do not need current income from their investments because they each earn a good living. Because they are probably in a fairly high tax bracket, any interest income and short-term capital gains from their investments would be taxed at their ordinary tax rate. Clearly, they would be better off with long-term capital gains and dividends which are currently taxed at a maximum rate of 15%, and capital gains are taxed only when the gains are realized. However, some amount of income producing securities, which could include bonds, should be included in a well balance portfolio because such investments tend to lower the overall risk of the portfolio and lend some amount of stability to price fluctuations. 3. The Ashcrofts should invest this money to supplement any retirement accounts they may have, and we will assume since they both have good jobs that they are contributing the maximum to their tax-sheltered retirement plans (if not, your first recommendation would be to fully fund all of these plans and/or IRAs). Next, have the Ashcrofts look over their balance sheet and see what rates they are paying on their debts. Particularly look at debts where the interest is not tax deductible (credit cards, personal loans, auto loans, etc.). Paying down high rate debt provides a guaranteed rate of return at the rate of the debt (if you’re paying on the debt, you’re paying out that rate of return; if you no longer have that debt, you are keeping that rate of return in your pocket and have it to invest). Having done these preliminaries, you would probably want to recommend a portfolio consisting mostly of diversified, high-quality stocks for long-term growth and some bonds to act (hopefully) as a cushion when the market goes down. Students will develop a portfolio from listings in Exhibits 11.5 and 12.10, with the exception of the money market mutual fund. Using only the two exhibits in the text limits the choices, obviously, and does not make for as diversified a portfolio as would be desired, but you will notice in the portfolio should have a representation of various industries. About two-thirds of the portfolio should be comprised of stocks while the other third should be fixed income securities. The bonds were chosen because they mature in a fairly short time period. At the time the portfolio was created, the prevailing interest rates were very low, so the idea was to buy shorter-term bonds and repurchase when interest rates rise. Shorter-term bonds have less price volatility and suffer less loss in value than do longer-term bonds when interest rates go up. Note that while Treasuries of the same maturity offered higher coupons, they were selling at larger premiums, making their yields lower than the corporate bond chosen. 12.2 Elaine Decides to Try Her Hand at Investing 1. Numerous options are open to Elaine, but due to her fairly conservative disposition, probably only high-quality bonds, blue chip common stocks, and high-quality growth stocks, as well as certain savings instruments, like certificates of deposit, are candidates for investment. The bonds falling into this category could be corporate, municipal, or federal government issues. 2. Historically, stocks have outperformed bonds, so Elaine has a good chance of earning a satisfactory return with any of the different stocks listed. However, the growth and speculative stocks will carry greater risk, particularly the speculative stocks. Whether Elaine earns an acceptable return on the bonds depends not only on the bond returns but also on her tax situation. Corporate bonds pay interest which would be taxed at her regular tax rate. The income from qualified municipal bonds is free from federal income taxes, but the yields on municipals are generally lower than those on corporate bonds. 3. Income vs. growth—Elaine is living comfortably and has been able to save quite a bit. Therefore, she probably does not want to invest with an income objective but rather with a growth orientation. Short-term vs. long-term—Elaine probably would want to invest this money for the long term, as she does not need it anytime soon and her salary is sufficient for her current living needs. Additionally, Elaine has given herself an emergency fund of $3,000 to handle any unexpected expenses. Level of risk—The risk-return trade off should also be considered when analyzing Elaine’s investment choices so as to maximize her return without exposing her to an unacceptable level of risk. 4. Suitable recommendations for Elaine’s portfolio would probably include some mixture of high-quality stocks and bonds, perhaps half and half or 60% stocks and 40% bonds. The stock portion should be comprised mostly of blue chips with perhaps several quality growth stocks. The bond portion should be comprised of investment grade short-term and intermediate-term bonds, as long-term bonds are subject to greater price fluctuations when interest rates change. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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