© 2008 Thomson South-Western CHAPTER 12 INVESTING IN STOCKS AND BONDS

12-2 The Risks Of Investing Business Financial Market Purchasing Power Interest Rate Liquidity Event

12-3 Returns from Investing  Current income  Capital gains  Interest-on-interest

12-4 Interest-on-Interest  Investment returns must be reinvested in order for compounding to take place  Utilizes the time value of money concepts presented earlier

12-5 Interest-on-Interest

12-6 The Risk-Return Trade-Off If you want GREATER RETURN, you will most likely have to accept GREATER RISK

12-7 The Risk-Return Trade-Off If you want GREATER RETURN, you will most likely have to accept GREATER RISK

12-8 The Risk-Return Relationship

12-9 What Makes A Good Investment?  Future return  Approximate yield  Desired rate of return

12-10 Investing in Common Stock  Each share represents equity or part ownership in the company.  Stock ownership allows the investor to participate in the profits of the firm.  Stock ownership is a residual; other obligations of company must be paid first.

12-11 The Dow and the NASDAQ,

12-12 –Usually one share = one vote –Most small shareholders assign their votes to a proxy, another party who will vote for them –Voting rights are not particularly important to small shareholders Voting Rights

12-13 –Short-term capital gains (sale of securities held less than one year) are taxed at regular income tax rates, which go up to over 30%. –Cash dividends and long-term capital gains (sale of securities held longer than one year) are taxed at a maximum rate of 15%. –Gains are not taxed until realized. Basic Tax Considerations

12-14 –Usually paid quarterly. –Can be paid even when company shows a loss. –Paid either in cash or in additional shares of stock. Dividends

12-15 –Stock dividends are paid in new shares given to current shareholders. –Cash dividends are most common and most desirable. Dividends

12-16 EPS = (Net profits after taxes – Preferred stock dividends paid) Number of shares outstanding  Earnings per Share (EPS) — amount of net income earned by one share of common stock Key Measures of Performance

12-17 –The market is used as a benchmark of performance and is assigned a beta of 1. –Stocks with betas < 1 are relatively less volatile in price swings. –Stocks with betas > 1 are relatively more volatile in price swings.  Beta — indicator of a stock’s price volatility relative to the market. Key Measures of Performance

12-18 Types of Common Stock  Blue-Chip — issued by large, well established companies. –Usually pay dividends, which lends price stability. –Returns are considered more dependable and less risky.

12-19 –Usually pay low or no dividends. –Typically experience more price volatility.  Tech — issued by companies in the technology sector. –Most are either growth or speculative stocks. –Some are blue-chip stocks.  Growth — issued by companies expected to have above average rates of growth in operations and earnings. Types of Common Stock

12-20 –Pay relatively high dividends. –Attractive to people who seek current income.  Speculative — issued by companies which are considered to have higher risk. –The company, its products, or the industry may be new or unproven. –Stock prices may be highly volatile.  Income — issued by companies which have a fairly stable stream of earnings. Types of Common Stock

12-21 –Most are found in basic industries. –Always have a positive beta.  Defensive — issued by companies whose stock prices usually remain stable during economic downturns. –Companies usually provide basic needs, such as consumer goods. –Betas are usually low or even negative.  Cyclical — issued by companies whose stock prices move in same direction as the business cycle. Types of Common Stock

12-22 –Usually offer greater returns than larger companies. –Stock prices tend to be less volatile than small caps.  Small Cap — issued by companies with market capitalization of $1 billion or less. –Offer possibility of high returns. –Prices can be very volatile due to high risk exposure.  Mid-Cap — issued by companies with market capitalization of $1–5 billion. Types of Common Stock

12-23 –Offer investors greater portfolio diversity. –International mutual funds and American Depositary Receipts (ADRs) provide convenient ways to invest in foreign securities. –Currency exchange rates can impact returns on investments.  Foreign stock — issued by companies from other countries Market Globalization and Foreign Stock

12-24 Investing in Common Stock  Advantages –Potential returns –Actively traded and highly liquid –Involve no direct management  Disadvantages –Risk –Timing of purchases and sales –Uncertainty of dividends

12-25 Investing in Common Stock

12-26 Making the Investment Decision  Putting a value on stock  The investment club approach  Timing your investments  Plow back your earnings –Dividend reinvestment plan (DRP)

12-27 Dividend Reinvestment Plan

12-28 Investing in Bonds  Fixed income security  Interest rates and bond prices move in opposite directions  Versatile  Preservation and long-term accumulation of capital

12-29 Bonds v. Stocks  Relative to stock, bonds have a lower return  But, lower risk

12-30 Bonds v. Stocks

12-31 Bond Issue Characteristics  A bond is loan—the bondholder is lending money to the bond issuer.  Generally, interest is paid to the bondholder every 6 months.  The coupon rate is the annual interest rate paid by the bond issuer.  The maturity date is when the loan ends and the bond issuer repays the principal to the bondholder.

12-32  Regardless of the market price paid for the bond, the bondholder will receive the par value at maturity.  Bonds offer current income during the time the bonds are held.  If sold before maturity, bonds can also generate capital gains (losses).  The par value is the amount of principal that must be repaid to the bondholder— usually $1000 on a corporate bond. Bond Issue Characteristics

12-33 The Bond Market  Treasury Bonds  Municipal Bonds  Corporate Bonds

12-34 The Bond Market  Treasury Bonds – U.S. Treasury obligation with maturity of more than 10 years that pays interest semiannually

12-35 The Bond Market  Municipal bonds –Issues of states, counties, cities, and other governmental subdivisions –Interest income is usually free from federal income tax (tax-free bonds)

12-36 The Bond Market Municipal bonds:

12-37 The Bond Market  Corporate bonds –Industrials –Public utilities –Rail and transportation bonds –Financial issues First mortgage bonds, convertible bonds, debentures, subordinated debentures, income bonds

12-38 Bond Ratings  A letter grade is assigned to new bond issues to designate investment quality.  The lower the rating, the greater the risk of default and the higher the coupon rate which must be offered.  Outstanding bonds are also reviewed regularly to ensure that their ratings are still valid.

12-39 Bond Ratings

12-40 Bond Ratings

12-41 Bond Prices and Yields  The price of a bond is a function of its coupon, length of maturity, and the movement of market interest rates.  Premium bond  Discount bond

12-42 Bond Prices

12-43 Bond Yields  The yield on a bond is the rate of return you would earn if you held the bond for a stated period of time.