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Chapter 7

Chapter 7. Investments. START. EXIT. Chapter Outline. 7.1 Stocks 7.2 Bonds 7.3 Mutual Funds and Investment Portfolios Chapter Summary Chapter Exercises. 7.1 Stocks.

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Chapter 7

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  1. Chapter 7 Investments START EXIT

  2. Chapter Outline 7.1 Stocks 7.2 Bonds 7.3 Mutual Funds and Investment Portfolios Chapter Summary Chapter Exercises

  3. 7.1 Stocks • Money can be put to work by loaning it to someone else. However, it can also be put to work by buying something that we hope will provide a good return on the money invested. • We could buy a piece of real estate or gold coins in the hope that they will increase in value. One of the main ways to put money to work, though, is by using it to start or buy part of a business.

  4. 7.1 Stocks • Businesses can legally be set up in a range of different ways. • In a sole proprietorship, the business is owned entirely by one individual, the person who runs it. Many small businesses are set up in this way. • A partnership is a business owned by two or more people, again typically the people who actually run the business. • A corporation is a legal entity that be thought of in many ways as an artificial legal person, able to own property, enter into contracts, borrow money, and conduct business and financial affairs. One of the biggest advantages of a corporation is that it exists as a separate legal entity from its owners; therefore, if things go badly, generally its owners cannot be held personally for any liabilities. • The ownership of a corporation is divided among its stockholders, each owning one or more pieces that are called shares of the company’s stock.

  5. 7.1 Stocks • How much of the business each share of stock represents depends on how many shares of stock the company has issued. • A corporation can have any number of shares, so it’s impossible to know how large a percent of the ownership one share represents unless you know the total number of shares issued.

  6. 7.1 Stocks • When stock is first issued by a corporation, it may be issued with a par value which is a reflection of a portion of the money paid by the original shareholders into the corporation. • However, today it is not unusual for a stock to have no par value, or to have a par value which is absurdly low compared to the realistic value of the stock.

  7. 7.1 Stocks • Some companies issue different types of stock. As its name suggests, common stock is the most common type, though preferred stock is another. • While both types of stock represent ownership of a piece of corporation, the two types differ in how their owners share in the company’s profits, who has first claim to the corporation’s remaining assets in the event it goes into bankruptcy, and in their voting rights in the election of the board of directors or the group of people who actually direct the corporation’s activities.

  8. 7.1 Stocks • The profits earned by a corporation properly belong to its shareholders, the people who own the corporation. • However, since the corporation is a separate legal entity, a shareholder does not have the right to access the corporation’s funds directly. • Some corporations pay their shareholders a portion of the profits known as a dividend. • Dividends are divided among the shareholders according to the number of shares each owns.

  9. 7.1 Stocks Example 7.1.1 • Problem • XYZ Systems earned $743,000 in the last quarter, and the company’s management declared a dividend of $450,000. The company has 1,000,000 shares of stock issued. If you own 200 shares, how much will you receive as a dividend? • Solution $450,000 ÷ 1,000,000 = $0.45 per share $0.45 x 200 = $90.00

  10. 7.1 Stocks Example 7.1.2 • Problem • Jason and Dave’s dry cleaning business is set up as a corporation. There are 100 shares of stock; Jason owns 51 shares and Dave owns 49. In the last quarter, the business earned $39,750 in profits and the company declared a dividend of $35,000. How much will Jason and Dave each get? • Solution $35,000 ÷ 100 = $350 per share $350 x 51 = $17,850 (Jason) $350 x 49 = $17,150 (Dave)

  11. 7.1 Stocks Example 7.1.3 • Problem • Suppose that TJ, Rudy, Eric, and Kevin have a band, which they have set up as a business partnership. They agree to distribute their profits in unequal shares because Rudy owns most of the band’s equipment and Eric wrote most of the songs. They agree to distribute the profits as follows: • TJ, 3 parts • Rudy, 5 parts • Eric, 4 parts • Kevin, 3 parts • The band earned $7,250 last month. How much does each person receive? • Solution Total shares = 3 + 5 + 4 + 3 = 15 Dividend per share = $7,250 ÷ 15 = $483.33 3 x $483.33 = $1,449.49 (TJ and Kevin) 4 x $483.33 = $1,933.32 (Eric) 5 x $483.33 = $2,416.65 (Rudy)

  12. 7.1 Stocks • It is often desirable to express a company’s dividend rate as a percent, to make comparisons more meaningful. This rate is called the stock’s dividend yield. • The shares of many large corporations can be bought and sold through stock brokers. • Large companies with many shares of stock typically have their shares listed on a major stock exchange such as the New York Stock Exchange or NASDAQ.

  13. 7.1 Stocks Example 7.1.4 • Problem • The market price per share of XYZ Systems is currently $49.75. Calculate the stock’s dividend yield. • Solution • The company is currently paying $0.45 per share quarterly (see Example 7.1.1). • This works out to a rate of 4 x $0.45 = $1.80 per year. • Dividend Yield = Annual Dividend ÷ Market Price per Share • Dividend Yield = $1.80 ÷ $49.75 = 3.62%

  14. 7.1 Stocks Example 7.1.5 • Problem • Most corporations pay dividends quarterly. However, sometimes a dividend yield will be calculated on the basis of the total dividends paid out by the company over the prior 12 months. • XYZ Systems has paid total dividends of $1.75 per share in the past 12 months. Calculate the stock’s dividend yield. • Solution $1.75 ÷ $49.75 = 3.52%

  15. 7.1 Stocks Example 7.1.6 • Problem • Stocks that are not readily available to be bought or sold are referred to as illiquid. Determining the market value of such stock is more difficult than for a liquid one because there are no other open market sale prices to compare with. • Dave believes that each share of stock in the dry cleaning business is worth $8,000. Based on this estimate, what is the dividend yield (see Example 7.1.2)? • Solution $350 per quarter annualizes to $1,400 per year. Therefore, Dividend Yield = $1,400 ÷ $8,000 = 17.5%

  16. 7.1 Stocks • Dividends are one way that an investor hopes to profit from a stock investment, but they are not the only one, or even necessarily the main one. • Often an investor buys shares in a business in the hopes that the business itself will grow and become more valuable, and that down the road s/he can sell shares for more than original cost. • Profits due to the increase in value of an investment are called capital gains.

  17. 7.1 Stocks • While both are a way of profiting from an investment, there are significant differences between capital gains and dividends. • If you own shares and receive dividends, you get them in cash and can do whatever you like with that money. • However, if you bought your shares for, say, $25 a share, and the price rises to $100 per share, on paper you have a profit of $75 but you don’t actually have this as money you can spend unless you sell your stock. • If the market price of the stock declines, your “profit” can disappear.

  18. 7.1 Stocks • There are some advantages to capital gains over dividends, though. When dividends are paid, they are income to you, and so they are subject to income tax. • Capital gains are not considered income until you make them income by selling, and so you do not pay income taxes on those gains until you sell the stock. • Also, capital gains may be taxed at a different (usually lower) rate than dividends. • Some companies and investors prefer that a stock not pay large (or any at all) dividends and invest almost all its profits in growing the business, the idea being that this will provide the opportunity for greater capital gains.

  19. 7.1 Stocks FORMULA 7.1.1 Compound Annual Growth Rate (CAGR) where i represents the COMPOUND GROWTH RATE FV represents the FUTURE VALUE PV represents the PRESENT VALUE n represents the NUMBER OF YEARS

  20. 7.1 Stocks Example 7.1.7 • Problem • You bought shares of XYZ Systems 7 years ago for $12.50 per share. The current stock price is $50 per share. If you sell your stock today, what compound annual growth rate will your capital gain represent? • Solution

  21. 7.1 Stocks Example 7.1.8 • Problem • Five years ago, I invested $8,400 in the stock of AAA Investment Corp. I sold the stock today for $1,750. What compound annual growth rate does this represent? • Solution

  22. 7.1 Stocks • The rate of return that we have calculated puts capital gains in terms of a rate of return. However, it completely ignores any dividends that might have been received along the way. • The overall return, including both capital gains and dividends, can be referred to as the total return on the investment.

  23. 7.1 Stocks Example 7.1.9 • Problem • The dividend yield rate on XYZ Systems has been on average around 3 ½% over the time you have owned it. What is the approximate total rate of return you have received on this investment? • Solution 21.90% + 3.50% = 25.40%

  24. 7.1 Stocks • The total return idea would be much simpler if the dividends were paid in company stock instead of in cash. In that case, the dividends would earn compound growth, as dividends are paid on the stock dividends, and so on. • Many companies offer dividend reinvestment plans. The money-dividends earned on stocks owned in these plans are not paid out but are instead used to purchase more stock at the market price.

  25. 7.1 Stocks Example 7.1.10 • Problem • Ten years ago, I invested $2,000 in a dividend reinvestment plan offered by my local electric utility company. The value of my original investment, including reinvested dividends, has grown to $3,525.18. What was my total rate of return? • Solution

  26. Section 7.1 Exercises

  27. Problem 1 • Herbal Collections, Inc. has declared total dividends of $500,000. If this corporation has 1,000,000 outstanding shares, what is a dividend per share? • If you own 20 shares, what are your total dividends? CHECK YOUR ANSWER

  28. Solution 1 • Herbal Collections, Inc. has declared total dividends of $500,000. If this corporation has 1,000,000 outstanding shares, what is a dividend per share? • If you own 20 shares, what are your total dividends? • Dividends per share = $500,000/1,000,000 = $0.50 • Dividends for 20 shares = 20 x $0.50 = $10 BACK TO GAME BOARD

  29. Problem 2 • Aegean Tours, Inc. declared total dividends of $3.00 per share. If its stock is currently selling for $134.83 per share, what is the current dividend yield? CHECK YOUR ANSWER

  30. Solution 2 • Aegean Tours, Inc. declared total dividends of $3.00 per share. If its stock is currently selling for $134.83 per share, what is the current dividend yield? • $3.00/$134.83 = 0.0225 = 2.23% BACK TO GAME BOARD

  31. Problem 3 • Five years ago, Rhonda bought stock in Shoemaker Manufacturing for $67.23 per share. The stock is now worth $75.12 per share. Calculate the compound annual growth rate for her investment. CHECK YOUR ANSWER

  32. Solution 3 • Five years ago, Rhonda bought stock in Shoemaker Manufacturing for $67.23 per share. The stock is now worth $75.12 per share. Calculate the compound annual growth rate for her investment. BACK TO GAME BOARD

  33. Problem 4 • Ross invested $1,000 in a company dividend reinvestment plan 3 years ago. Today, his account is worth $7,400. Calculate the total rate of return on his investment. CHECK YOUR ANSWER

  34. Solution 4 • Ross invested $1,000 in a company dividend reinvestment plan 3 years ago. Today, his account is worth $7,400. Calculate the total rate of return on his investment. BACK TO GAME BOARD

  35. 7.2 Bonds • Recall that a promissory note is simply a written agreement between a borrower and a lender, specifying the terms of a loan. • Speaking generally, a bond can be thought of as a type of promissory note. • The term bond is more commonly used when the borrower makes periodic interest payments to the lender, instead of repaying the entire principal and interest all at once at maturity. • Also, while simple interest or simple discount promissory notes tend to be fairly short term loans, bonds often extend for longer terms.

  36. 7.2 Bonds • The issuer of the bond is the entity that creates the bond as a means to borrow funds. Therefore, the issuer is the borrower. • When a bond is first sold, its buyer pays the issuer some amount of money in exchange for the bond. Therefore, the initial buyer of a bond is the lender. • The issuer is obligated to make certain payments to the bond’s owner. • The par value or the face value of a bond is the amount that will be paid to the bond’s owner at maturity.

  37. 7.2 Bonds • A bond is said to be redeemed when the borrower pays the bond’s owner its par value. For this reason, the par value is also sometimes referred to as the redemption value. • Normally, redemption occurs at the bond’s maturity date, though some bonds include a provision that the debt can be paid off early, possibly at either the issuer or the owner’s option. • When the bond is redeemed early, we say it is called and bonds that may be called are said to be callable. • The coupon rate is the interest rate for the bond’s periodic interest payments. • There are two types of bonds: • With a registered bond, the owner is recorded by the issuer and interest payments are sent to this registered owner. If that type of bond is sold, the issuer must be notified. This solves the problem of where to send payments but it creates a burden of record-keeping. • With a coupon bond, there are actual coupons attached to the bond which the current owner clips off and submits when interest payments are due.

  38. 7.2 Bonds Example 6.2.1 • Problem • On May 25, 2007, XYZ Systems issued a $1,000 par value bond with an 8% coupon rate and a May 25, 2019, maturity date. Interest will be paid semiannually. What payments will the owner of this bond receive? • Solution • The owner will receive the par value, $1,000, on the maturity date of May 25, 2019. • Interest payments will be made semiannually, on November 25 and May 25 of each year until maturity. • The amount of each interest payment will be: I = PRT = $1,000 x 8% x ½ = $40

  39. 7.2 Bonds • When a bond is issued, the par value and coupon rate are set in advance. The amount that the issuer will receive for each bond is not. • In an ideal situation, each bond would sell for its par value, so that the coupon rate would be equal to the actual interest rate. When this happens, we say that the bond is sold at par. This seldom actually happens, though. • If the market decides that the bond’s issuer is a good credit risk and the coupon rate is attractive, buyers may be willing to pay more than the par value for the bond. We say then that the bond sells at a premium. • On the other hand, if the issuer is not considered quite so good a risk and the coupon rate is not that attractive, the issuer may not be able to sell the bond for its full par value. In that case, we say that the bond sells at a discount.

  40. 7.2 Bonds Example 7.2.2 • Problem • Suppose that XYZ Systems is financially sound and the consensus of the investment community is that the company’s prospects are excellent. Right now, investors can earn around a 7% rate of return by buying bonds with similar maturities issued by similarly sound companies. Would you expect XYZ’s bonds to sell at par, at a premium, or at a discount (see Example 7.2.1)? • Solution • If you buy the bond at par, you will earn 8% of return when comparable investments pay only 7%. Therefore, in the open market, these bonds will almost certainly sell at a premium.

  41. 7.2 Bonds Example 7.2.3 • Problem • The current yield of a bond is the interest rate that the bond pays as a percent of the current market price. • Suppose that one of the May 25, 2019, 8% XYZ Systems bonds sells for $1,094. What is the current yield? • Solution • We have already determined that the interest payments are $40 semiannually. I = PRT $40 = $1,094 x R x 1/2 R = 7.31%

  42. 7.2 Bonds • The yield to maturity of a bond is a measurement of the actual interest rate that will be earned, assuming that the bond is held to maturity. • Unlike the current yield, the yield to maturity takes into account the effect of any premium (or discount) to maturity value.

  43. 7.2 Bonds • Even though bonds generally carry less risk and volatility than stocks, they are by no means risk- and volatility-free. • Every bond carries with it some credit risk. • There are several rating agencies, companies whose business is to evaluate how great this risk is with any given bond issuer. • Bonds of issuers whose ratings are deemed to be reasonably secure are sometimes referred to as investment grade bonds. • Bonds of issuers whose ratings fall in a range suggesting that there is a realistic cause for concern are sometimes referred to as junk bonds.

  44. 7.2 Bonds • Savings bonds are issued by the United States federal government and can be purchased through many banks and other financial institutions. • Inflation-protected securities are bonds, almost always issued by the federal government, whose coupon rates vary depending on the inflation rate. • Zero coupon bonds are long-term bonds which do not make any interest payments prior to maturity. • Municipal bonds are bonds issued by state and local governments. In many cases, the interest paid on these bonds is exempt from federal income taxes, and so these bonds often carry much lower interest rates.

  45. 7.2 Bonds Example 7.2.8 • Problem • Laurie bought a $50 face value savings bond for $25. Sixteen years later, she cashed the bond in for $79.36. What effective rate of compound interest did she earn on this bond? • Solution

  46. Section 7.2 Exercises

  47. Problem 1 • You paid $372.50 for ten $40 par value bonds carrying a 3% coupon rate. How much will you receive in semiannual interest payments from this investment? How much will you receive at maturity? CHECK YOUR ANSWER

  48. Solution 1 • You paid $372.50 for ten $40 par value bonds carrying a 3% coupon rate. How much will you receive in semiannual interest payments from this investment? How much will you receive at maturity? • Semiannual Interest Payments • I =PRT I = $372.50 x 3% x ½ = $5.59 • At Maturity • $40 x 10 = $400 BACK TO GAME BOARD

  49. Problem 2 • Richard purchased a bond for $2,945. The par value is $3,100 and the coupon rate is 5 ¼%. Find the current yield semiannually. CHECK YOUR ANSWER

  50. Solution 2 • Richard purchased a bond for $2,945. The par value is $3,100 and the coupon rate is 5 ¼% for 6 months. Find the current yield. • I = PRT I = $3,100 x 5 ¼% x ½ = $81.38 $81.38 = $2,945 x R x ½ $81.38 = $1,472.50 x R R = 5.5% BACK TO GAME BOARD

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