1. PFIN 12 Investing in Stocks and Bonds 5 BILLINGSLEY/ GITMAN/ JOEHNK
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2. LEARNING OUTCOMES
Describe various types of risk to which investors are exposed, as well as the sources of return
Know how to search for an acceptable investment on the basis of risk, total return, and yield
Discuss the merits of investing in common stock and be able to distinguish among the different types of stocks
PFIN5 | CH12
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3. LEARNING OUTCOMES (continued)
Become familiar with the various measures of performance and how to use them in placing a value on stocks
Describe the basic issue characteristics of bonds as well as how these securities are used as investment vehicles
Distinguish between the different types of bonds, gain an understanding of how bond prices behave, and know how to compute different measures of yield
PFIN5 | CH12
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4. Risks of Investing Business Financial Market
Variability associated with a firm’s cash flows and with its ability to meet its operating expenses
Business
Associated with mix of debt and equity financing used by the issuing firm and ability to meet its financial obligations
Financial
Associated with the price volatility of a security
Market
PFIN5 | CH12
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5. Risks of Investing Purchasing power Interest rate Liquidity Event
Results from possible changes in price levels
Purchasing power
Results from changing market interest rates
Interest rate
Risk associated with the inability to liquidate an investment at a reasonably price
Liquidity
Unexpected event leading to a sudden and sizeable change in the value of an investment
Event
PFIN5| CH12
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6. Returns from Investing
Current income - Received with some degree of regularity over a year
Capital gains - Reflected as an increase in the market value of an investment vehicle
Earning interest on interest
PFIN5 | CH12
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7. Exhibit 12.2 The Risk-Return Relationship PFIN5 | CH1
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8. Components of a Good Investment
Future return
Approximate yield
Provides a measure of the fully compounded rate of return from an investment
Desired rate of return: Minimum rate of return earned in compensation for the amount of risk assumed
PFIN5 | CH12
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9. Performance of Dow Jones Industrial Average and NASDAQ Composite, 2004 through 2014
Exhibit 12.3
Source: Morningstar 2013.
PFIN5/CH12
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10. Investing in Common Stock
Issuers of common stock
Issued by any corporation in any line of business
Voting rights - For each share of stock held holders receive one vote
Proxy: Written statement used to assign a stockholder’s voting rights to another person
Basic tax considerations
Common stocks provide income in the form of dividends and/or capital gains
PFIN5 | CH12
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11. Dividend yield: Percentage return provided by the dividends
Paid by firms to their common stock holders in cash and/or additional stock
Dividend yield: Percentage return provided by the dividends
Stock dividends
New shares of stock distributed to existing stock holders as a supplement for cash dividends
PFIN5 | CH12
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12. Key Measures of Performance
Book value: Amount of stockholder’s equity in a firm
Net profit margin: Relates a firm’s net profits to its sales
Return on equity (ROE): Captures the firm’s overall profitability
PFIN5 | CH12
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13. Key Measures of Performance
Earnings per share (EPS): Return earned by each share of common stock
Price/earnings (P/E) ratio: Measure of investors’ confidence in a given security
Beta: Index of the price volatility for a share of common stock
PFIN5 | CH12
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14. Types of Common Stock Blue-chip Growth Tech
Provides an continuous stream of dividends and long-term growth prospects
Blue-chip
Earnings and/or market price have increased over time at a above average rate
Growth
Represents the technology sector of the market
Tech
PFIN5 | CH12
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15. Types of Common Stock Income Speculative Cyclical Defensive
Offers dividend payments that can be expected to increase over time
Income
Purchased with a hope that its price per share will increase
Speculative
Price movements tend to parallel the various stages in the business cycle
Cyclical
Price movements are contrary to movements in the business cycle
Defensive
PFIN5 | CH12
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16. Reasons for Investing in Common Stock
Using the stock as a warehouse of value
Accumulating capital
Providing source of income
PFIN5 | CH12
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17. Stock Ownership Advantages Disadvantages Potential returns
Actively traded and are highly liquid form of investment
Available market and company information
Disadvantages
Risk
Problem of timing purchases and sales
Uncertainty of dividends
PFIN5 | CH12
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18. Making the Investment Decision
Putting a value on stock
Timing the investments
Being sure to gain earnings
Dividend Reinvestment Plan (DRP): Allowing stockholders to take their cash dividends in the form of more shares of the firm's stock
PFIN5 | CH12
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19. Types of Bonds
Coupon: Defines the annual interest income paid to bondholder by the issuer
Types of issues
Mortgage bond: Secured by a claim on real assets
Equipment trust certificates: Secured by certain types of equipment
PFIN5 | CH12
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20. Basic Issue Characteristics of Bonds
Debentures: Unsecured bond issued on the general credit of the firm
Sinking fund: Specifies the annual repayment schedule to be used in paying off the issue
Call feature: Allows the issuer to retire the security prior to maturity
PFIN5 | CH12
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21. Bond Market Treasury bond Agency bond
Issued and backed by the full faith and credit of the U.S. government
Treasury inflation-indexed bond (TIPS): Principal payments adjusted to provide protection against inflation
Agency bond
Obligation of a political subdivision of the U.S. government
PFIN5 | CH12
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22. Mortgage-backed securities
Bond Market
Mortgage-backed securities
Claim on the cash flows generated by mortgage loans
Municipal bonds: Issued by state or local governments
Serial obligations: Issue broken down into a series of smaller bonds with own maturity date and coupon rate
PFIN5 | CH12
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23. Corporate bonds: Issued by a corporation
Bond Market
Revenue bonds: Serviced from the income generated by a specific project
General obligation bonds: Backed by the full faith and credit of the issuing municipality
Corporate bonds: Issued by a corporation
PFIN5 | CH12
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24. Bond Market Convertible bonds
Conversion privilege: Stipulates the conditions of the conversion feature
Conversion ratio: Specifies the number of shares of common stock into which a convertible bond can be converted
PFIN5 | CH12
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25. Bond Market
Conversion value: Measure of what a convertible issue would trade for if it were priced to sell based on its stock value
Conversion premiums: Difference between a convertible security’s market price and its conversion value
PFIN5 | CH12
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26. Exhibit 12.6 Moody’s and Standard & Poor’s Bond Ratings PFIN5 | CH12
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27. All bonds are priced as a percentage of par
Pricing a Bond
All bonds are priced as a percentage of par
Priced in decimals in the corporate and municipal market
Accrued interest: Amount of interest earned since the last coupon payment date by the bond holder/seller
Clean Price: Quoted price of a bond minus accrued interest
Dirty Price: Quoted price of a bond plus accrued interest
PFIN5 | CH12
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28. Bond price depends on its:
Bond Prices and Yields
Bond price depends on its:
Coupon
Maturity
Movement of market interest rates
Premium bond: Market value is higher than par
Discount bond: Market value is lower than par
PFIN5 | CH12
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29. Bond Prices and Yields Current yield Yield to maturity
Amount of current income a bond provides relative to its market price
Yield to maturity
Fully compounded rate of return that bond would yield if held to maturity
PFIN5 | CH12
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30. KEY TERMS Proxy Business risk Dividend yield Financial risk
Market risk
Purchasing power risk
Fixed income securities
Interest rate risk
Liquidity risk
Event risk
Risk-free rate of return
Desired rate of return
Residual owners
Proxy
Dividend yield
Stock dividends
Book value
Net profit margin
Return on equity (ROE)
Earnings per share (EPS)
Price/earnings (P/E) ratio
PFIN5 | CH12
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31. KEY TERMS Dividend reinvestment plan (DRP) Beta Blue-chip stock Coupon
Mortgage bond
Equipment trust certificate
Debenture
Sinking fund
Call feature
Treasury bond
Treasury inflation- indexed bond (TIPS)
Beta
Blue-chip stock
Growth stock
Tech stock
Income stock
Speculative stock
Cyclical stock
Defensive stock
Large-cap stock
Mid-cap stock
Small-cap stock
PFIN5 | CH12
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32. KEY TERMS Agency bond Mortgage-backed securities Municipal bond
Serial obligation
Revenue bond
General obligation bond
Corporate bond
Conversion privilege
Conversion ratio
Conversion value
Conversion premium
Junk bond
Accrued interest
Clean price
Dirty (full) price
Premium bond
Discount bond
Current yield
Yield to maturity
PFIN5 | CH12
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33. SUMMARY
Investors are exposed to business, financial, market, purchasing power, interest rate, liquidity, and event risks
Sources of return - Current income, capital gains, and interest
An investment is acceptable only if it is expected to generate a rate of return meets one’s desired rate of return
Types of stock
Blue-chip, growth, tech, income, speculative, cyclical, defensive, and market-cap
PFIN5 | CH12
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34. Measures of performance
SUMMARY
Measures of performance
Book-value, net-profit margin, ROE, EPS, P/E ratio, and beta
Bonds are referred to as fixed-income securities as the debt service obligations of the issuer are fixed
Types of bonds
Treasury, agency, mortgage-backed, municipal, corporate, and convertible
PFIN5 | CH12
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