Using Securities
Markets for Financing and
Investing Opportunities
Chapter 19
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
1. Describe the role of securities markets.
2. Advantages & disadvantages of equity financing by issuing stock, and the differences between common and preferred stock.
3. Advantages & disadvantages of obtaining debt financing by issuing bonds, and identify types and features of bonds.
4. Explain investing in securities markets, setting & balancing investment objectives, and managing risks.
5. Analyze investment opportunities stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
6. Describe market indicators like the Dow Jones Industrial Average, NASDAQ, and S&P 500.
LEARNING GOALSChapter Nineteen
19-2
• Securities markets are financial marketplaces for stocks and bonds and serve two primary functions:
1. Assist businesses in finding long-term funding to finance capital needs.
2. Provide private investors a place to buy and sell securities such as stocks and bonds.
The BASICS of SECURITIES MARKETS
The Function of Securities Markets
LG1
19-3
• Securities and Exchange Commission (SEC) -- The federal agency responsible for regulating the various stock exchanges; created in 1934 through the Securities and Exchange Act.
• Prospectus -- A condensed version of economic and financial information that a company must file with the SEC before issuing stock; the prospectus must be sent to prospective investors.
• Initial Public Offering (IPO) -- The first offering of a corporation’s stock, usually managed by an investment banker.
The SECURITIES and EXCHANGE COMMISSION
Securities Regulations and the SEC
LG2
19-4
• Dow Jones Industrial Average -- The average cost of 30 selected industrial stocks.
• Critics say the 30-company Dow is too small a sample and suggest following the S&P 500.
• S&P 500 tracks the performance of 400 industrial, 40 financial, 40 public utility, and 20 transportation stocks.
KEY STOCK MARKET INDICATORS
Understanding Stock Market Indicators
LG9
19-5
• Stock Exchange -- An organization whose members can buy and sell (exchange) securities on behalf of companies and individual investors.
• Over-the-Counter (OTC) Markets -- Provides smaller publically traded companies and investors with a means to trade stocks not listed on the national securities exchanges.
• NASDAQ -- A telecommunications network that links dealers across the nation so they can exchange securities electronically.
STOCK EXCHANGESStock Exchanges
LG2
19-6
• NYSE Euronext
• NASDAQ
• London Stock Exchange
• Tokyo Stock Exchange
• Deutsche Borse
TOP STOCK EXCHANGESLG2
Stock Exchanges
19-7
• Stocks -- Shares of ownership in a company.
• Stock Certificate -- Evidence of stock ownership.
• Dividends -- Part of a firm’s profits that the firm may distribute to stockholders as either cash or additional shares.
LEARNING the LANGUAGE of STOCKS
How Businesses Raise Capital by Selling Stock
LG3
19-8
• Stockholders are owners of a firm and never have to be repaid their investment.
• There’s no legal obligation to pay dividends.
• Issuing stock can improve a firm’s balance sheet since stock creates no debt.
ADVANTAGES of ISSUING STOCK
Advantages & Disadvantages of Issuing Stock
LG3
19-9
• Stockholders have the right to vote for a company’s board of directors.
• Issuing new shares of stock can alter the control of the firm.
• Dividends are paid from after-tax profits and are not tax deductible.
• The need to keep stockholders happy can affect management’s decisions.
DISADVANTAGES of ISSUING STOCKLG3
Advantages & Disadvantages of Issuing Stock
19-10
• Common Stock -- The most basic form; holders have the right to vote for the board of directors and share in the profits if dividends are approved.
• Preferred Stock -- Owners are given preference in the payment of company dividends before common stock dividends are distributed. Preferred stock can also be:- Callable
- Convertible
- Cumulative
TWO CLASSES of STOCK
Issuing Shares of Common and Preferred Stock
LG3
19-11
• Stock Splits -- An action by a company that gives stockholders two or more shares of additional stock for every share that they own.
• Splits cause no change in the firm’s ownership structure and no change in the investment’s value.
• Firms can never be forced to spilt their stocks.
STOCK SPLITSStock Splits
LG6
19-12
• Bond -- A corporate certificate indicating that an investor has lent money to a firm (or a government).
LEARNING the LANGUAGE of BONDS
Learning the Language of Bonds
• The principal is the face value of the bond.
• Interest -- The payment the bond issuer makes to the bondholders to compensate them for the use of their money.
LG4
19-13
• Bondholders are creditors, not owners of the firm and can’t vote on corporate matters.
• Bond interest is tax deductible.
• Bonds are a temporary source of funding and are eventually repaid.
• Bonds can be repaid before the maturity date if they contain a call provision.
ADVANTAGES of ISSUING BONDS
Advantages & Disadvantages of Issuing Bonds
LG4
19-14
• Bonds increase debt and can affect the market’s perception of the firm.
• Paying interest on bonds is a legal obligation.
• If interest isn’t paid, bondholders can take legal action.
• The face value of the bond must be repaid on the maturity date.
DISADVANTAGES of ISSUING BONDSLG4
Advantages & Disadvantages of Issuing Bonds
19-15
• Corporations can issue two classes of bonds:
DIFFERENT CLASSES of CORPORATE BONDS
Different Classes of Bonds
1. Unsecured bonds (debenture bonds): not backed by specific collateral.
2. Secured bonds: backed by collateral (land or equipment).
LG4
19-16
• First-time bond investors generally ask two questions:
- Do you have to hold a bond until the maturity date?
- How can I assess the investment risk of a particular bond issue?
• Junk Bonds -- Bonds that are high-risk and have high default rates.
IMPORTANT BOND QUESTIONSInvesting in Bonds
LG7
19-17
BOND RATINGS
Rating
Moody’s S & P Fitch Description
Aaa AAA AAA Highest Quality
Aa AA AA High Quality
A A A Upper-Medium Grade
Baa BBB BBB Medium Grade
Ba BB BB Lower-Medium Grade
B B B Speculative
Caa CCC, CC CCC Poor
Ca C DDD Highly Speculative
C D D Lowest Grade
LG4
Advantages & Disadvantages of Issuing Bonds
19-18
• Stockbroker -- A registered representative who works as a market intermediary to buy and sell securities for clients.
• Online trading services, such as TD Ameritrade, E*Trade, and Scottrade, offer securities trading services online to buy and sell stocks and bonds.
BUYING SECURITIESHow Investors Buy Securities
LG5
19-19
PRIMARY INVESTMENT SERVICES CONSUMERS NEED
• Savings and investing advice
• Help with 401k plans
• Retirement planning
• Tax planning
• Estate planning
• Education expense planning
Source: Investment Company Institute.
LG5
Reducing Risk by Diversifying Investments
19-20
PERCENTAGE of HOUSEHOLDS OWNING MUTUAL FUNDS
Source: Investment Company Institute Factbook.
LG8
Investing in Mutual Funds & Exchange-Traded Funds
19-21
TOP FINANICIAL NEWS and RESEARCH SITES
• Yahoo Finance
• DailyFinance
• MSN Money
• Forbes
• Dow Jones & Co.
LG6
Understanding Stock Quotations
19-22
1. Investment risk
2. Yield
3. Duration
4. Liquidity
5. Tax consequences
FIVE INVESTMENT CRITERIAChoosing the Right Investment Strategy
LG5
19-23
AVERAGE ANNUAL RETURN of ASSET CLASSES (Since 1926)
Source: Ibbotson Associates and Morningstar.
LG5
Choosing the Right Investment Strategy
19-24
The greater the risk, the greater the rewards
COMPARING INVESTMENTSLG8
Understanding Mutual Fund Quotations
19-25
• Diversification -- Buying several different types of investments to spread the risk of investing.
• If diversifying, an investor may put: - 25% of his/her money into U.S. growth stocks
- 25% in government bonds
- 25% in dividend-paying stocks
- 10% in an international mutual fund
- The rest in a savings account
DIVERSIFICATIONReducing Risk by Diversifying Investments
LG5
19-26
• Mutual Fund -- An organization the buys stocks and bonds and then sells shares in those securities to the public. The fund pools investors’ money and buys stocks according to the fund’s purpose.
• Exchange-Traded Fund (ETF) -- Collections of stocks and bonds that are traded on securities exchanges, but are traded more like individual stocks than mutual funds.
INVESTING in MUTUAL FUNDS and EXCHANGE-TRADED FUNDS
Investing in Mutual Funds & Exchange-Traded Funds
LG8
19-27
VARIETIES of ETFs
Source: Schwab and E*Trade.
LG8
Investing in Mutual Funds & Exchange-Traded Funds
19-28
INVESTING 101Things to Do Before Making Your First Investment
Source: Money, November 2010.
LG5
Choosing the Right Investment Strategy
• Take an investing class.
• Join an investment club, or reputable web site like Motley Fool, not Motley Crue.
• Attend a conference (be very careful in selecting).
• Head to the library and pick up these books:
- The Big Short
- The Intelligent Investor
- The Myth of the Rational Market19-29
• Capital Gains -- The positive difference between the price at which you bought a stock and what you sell it for.
• Investors can also choose stocks according to their strategy:
- Blue-chip stocks
- Growth stocks
- Income stocks
- Penny stocks
SELECTING STOCKSLG6
Investing in Stocks
19-30
• Suggestions for building your financial future:
- Invest in global companies you know and that have solid performance records.
- Invest in global stocks listed on U.S. exchanges.
- Contact U.S. brokers about American Depository Receipts (ADRs).
- Invest in global mutual funds that focus on specific countries or regions.
- Use extreme caution if investing in unstable countries!
The SUN NEVER SETS on STOCK OPPORTUNITIES
(Reaching Beyond Our Borders)
19-31
• The stock market has its shares of ups and downs:
MARKET TURMOIL
- October 29, 1929 - Black Tuesday; the market lost 13% of its value.
- October 19, 1987 - The market suffered its worst one-day drop when it lost 22% of its value.
- October 27, 1997 - Fears of an economic crisis in Asia cause widespread panic and losses.
LG9
Riding the Market’s Roller Coaster
19-32
• Bulls: Investors who believe stock prices are going to rise.
PERCEPTIONS of the MARKET“Animal Spirits”
Investing in Stocks
• Bears: Investors who expect stock prices to decline.
LG6
19-33
• Bull markets are all alike, but every bear market is bad in its own way.
• Stock market is usually the messenger of the problem, but not always.
• Lack of confidence
BEAR MARKET DECLINES in the S&P 500
Source: Stock Traders Almanac 2011.
LG6
Investing in Stocks
19-34
• The market collapsed into a deep decline in 2000-2002 when the dot-com bubble burst.
- Investors lost $7 trillion in market value.
• Starting in 2008, the collapse of the real estate market sent financial markets into panic.
- The U.S. government made significant investments in private banks and offered a large stimulus package to re-energize the economy.
TURMOIL in the 2000sLG9
Riding the Market’s Roller Coaster
19-35
• Program Trading -- Giving instructions to computers to automatically sell if the price of a stock dips to a certain point to avoid potential losses.
‾ High Frequency Trading increases potential for greater volatility.
• Analysts believe program trading caused the turmoil in 1987.
• The exchanges created mechanisms to restrict program trading.
The UPS and DOWNS of the MARKET
Riding the Market’s Roller Coaster
LG9
19-36
• Buying Stock on Margin -- Borrowing some of the stock’s purchase cost from the brokerage firm.
BUYING STOCK on MARGINBuying Stock on Margin
• Margin is the portion of the stock’s purchase price that the investor must pay with their own money.
• If a broker issues a margin call, the investor has to come up with money to cover losses.
LG6
19-37
• Wall Street – • Issued exotic securities;
− Securitization (Selling mortgages or contracts for upfront payment (lead to bankruptcies of Enron ‘01 & Continental Illinois ‘84)
− Bond rating agencies gave AAA rating to MBS
• Paid excessive compensation based on bonuses
• Investment banks got the SEC to relax capital requirements.
• Main Street – • Americans borrowed beyond their means;
• Banks grew fast by giving favorable loans to homebuilders
• Homeowners took out equity loans
• ARM mortgage rates fueled Housing market bubble
WHO’S at FAULT for the ECONOMIC CRISIS?
Source: Fortune Magazine, www.fortune.com, accessed July 2011.
LG9
Riding the Market’s Roller Coaster
19-38
• Washington • Gramm-Leach-Billey Act allowed commercial & investment
banks to combined
• Fed kept interest rates low in a bid to boost economy
• Community Reinvestment Act required lending to people with bad credit.
• FNMA (Fannie Mae) & FHLMC (Freddie Mac) expanded significantly, buying ~ 90% of home mortgages
WHO’S at FAULT for the ECONOMIC CRISIS?
Source: Fortune Magazine, www.fortune.com, accessed July 2011.
LG9
Riding the Market’s Roller Coaster
19-39
• Investment Bankers -- Specialists who assist in the issue and sale of new securities.
INVESTMENT BANKERS and INSTITUTIONAL INVESTORS
The Role of Investment Bankers
LG1
• Institutional Investors -- Large organizations such as pension funds or mutual funds that invest their own funds or the funds of others.
19-40
• Congress passed the Dodd-Frank Financial Reform and Consumer Protection Act into law on July 21, 2010.
• Gives the government power to seize and shutter large financial institutions on the verge of collapse in an effort to prevent further bailouts.
• Formed an independent consumer protection agency housed within the Federal Reserve, protecting borrowers against a host of financial abuses ranging from payday loans to mortgages and credit cards.
CLEANING UP the STREET(Legal Briefcase)
19-41
• What’s the primary purpose of a securities exchange?
• What does NASDAQ stand for? How does this exchange work?
PROGRESS ASSESSMENTProgress Assessment
19-42
• Name at least two advantages and disadvantages of a company’s issuing stock as a form of equity financing.
• What are the major differences between common stock and preferred stock?
PROGRESS ASSESSMENTProgress Assessment
19-43
• Why are bonds considered a form of debt financing?
• What does it mean if a firm issues a 9% debenture bond due in 2025?
• Explain the difference between an unsecured and secured bond.
• Why are convertible bonds attractive to investors?
PROGRESS ASSESSMENTProgress Assessment
19-44
• What is the key advantage of investing through online brokers? What is the key disadvantage?
• What is the primary purpose of diversifying investments?
PROGRESS ASSESSMENTProgress Assessment
19-45
• What is a stock split? Why do companies sometimes split their stock?
• What does buying stock on margin mean?
• What are mutual funds and ETFs?
• What is the key benefit to investors in investing in a mutual fund or ETF?
PROGRESS ASSESSMENTProgress Assessment
19-46
• What does the Dow Jones Industrial Average measure? Why is it important?
• Why do the 30 companies comprising the Dow change periodically?
• Explain program trading and the problems it can create.
PROGRESS ASSESSMENTProgress Assessment
19-47