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