CHAPTER 19 Using Securities Markets for Financing Investing

CHAPTER 19 Using Securities Markets for Financing & Investing Opportunities Mc. Graw-Hill/Irwin Copyright © 2015 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

LEARNING OBJECTIVES 1. Describe the role of securities markets and of investment bankers. 2. Identify the stock exchanges where securities are traded. 3. Compare the advantages and disadvantages of equity financing by issuing stock, and detail the differences between common and preferred stock. 4. Compare the advantages and disadvantages of obtaining debt financing by issuing bonds, and identify the classes and features of bonds. 19 -2

LEARNING OBJECTIVES 5. Explain how to invest in securities markets and set investment objectives such as long-term growth, income, cash, and protection from inflation. 6. Analyze the opportunities stocks offer as investments. 7. Analyze the opportunities bonds offer as investments. 8. Explain the investment opportunities in mutual funds and exchange-traded funds (ETFs). 9. Describe how indicators like the Dow Jones Industrial Average affect the market. 19 -3

MELODY HOBSON Ariel Investments • Hobson started as an intern at Ariel Investments after graduating from Princeton in 1991. • Now, as president of the company, she oversees more than $9 billion in assets. • Preaches patience in investing. • Ariel Investments focuses on stocks and equity funds that should perform in the long term. 19 -4

NAME that COMPANY If someone had bought 100 shares in this company when it was first available to the public in 1965, it would have cost $2, 250. If they held on to the stock, the number of shares they’d have today would be 74, 360 (after 12 stock splits) with a value of approximately $7. 4 million. Name that company! 19 -5

The BASICS of SECURITIES MARKETS LO 19 -1 • 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. 19 -6

TYPES of SECURITIES MARKETS LO 19 -1 • Securities markets are divided into primary and secondary markets: - Primary markets handle the sale of new securities. - Secondary markets handle the trading of securities between investors with the proceeds of the sale going to the seller. • Initial Public Offering (IPO) -- The first offering of a corporation’s stock. 19 -7

INVESTMENT BANKERS and INSTITUTIONAL INVESTORS LO 19 -1 • Investment Bankers -- Specialists who assist in the issue and sale of new securities. • Institutional Investors -Large organizations such as pension funds or mutual funds that invest their own funds or the funds of others. 19 -8

STOCK EXCHANGES LO 19 -1 • Stock Exchange -- An organization whose members can buy and sell (exchange) securities on behalf of companies and individual investors. • Over-the-Counter (OTC) Market -- Provides 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. 19 -9

TOP STOCK EXCHANGES LO 19 -1 • NYSE Euronext • NASDAQ • London Stock Exchange • Tokyo Stock Exchange • Deutsche Borse 19 -10

GIVING SMALL BUSINESS a JUMP on FUNDING • The goal of the JOBS Act is to ease small business financing problems. • The SEC adopted new rules, including: - Raised from 500 to 2, 000 the number of shareholders a company could have before it must register its stock with the SEC. - Allows equity crowdfunding through brokers or portals. - Expanded the abilities of private companies to raise capital through limited stock offerings. 19 -11

The SECURITIES and EXCHANGE COMMISSION LO 19 -2 • 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. 19 -12

TEST PREP • What is the primary purpose of a securities exchange? • What does NASDAQ stand for? How does this exchange work? 19 -13

LEARNING the LANGUAGE of STOCKS LO 19 -3 • 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. 19 -14

ADVANTAGES of ISSUING STOCK LO 19 -3 • Stockholders are owners of a firm and never have to be repaid their investment. • There is no legal obligation to pay dividends. • Issuing stock can improve a firm’s balance sheet since stock creates no debt. 19 -15

DISADVANTAGES of ISSUING STOCK LO 19 -3 • 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. 19 -16

TWO CLASSES of STOCK LO 19 -3 • 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 19 -17

TEST PREP • 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? 19 -18

LEARNING the LANGUAGE of BONDS LO 19 -4 • Bond -- A corporate certificate indicating that an investor has lent money to a firm (or a government). • 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. 19 -19

TYPES of BONDS LO 19 -4 19 -20

ADVANTAGES of ISSUING BONDS LO 19 -4 • Bondholders are creditors, not owners of the firm and cannot 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 are callable. 19 -21

DISADVANTAGES of ISSUING BONDS LO 19 -4 • Bonds increase debt and can affect the market’s perception of the firm. • Paying interest on bonds is a legal obligation. • If interest is not paid, bondholders can take legal action. • The face value of the bond must be repaid on the maturity date. 19 -22

BOND RATINGS LO 19 -4 19 -23

DIFFERENT CLASSES of CORPORATE BONDS LO 19 -4 • Corporations can issue two classes of bonds: 1. Unsecured bonds (debenture bonds): not backed by specific collateral. 2. Secured bonds: backed by collateral (land or equipment). 19 -24

SPECIAL FEATURES in BOND ISSUES LO 19 -4 • Sinking Fund -- Reserve account set up to ensure that enough money will be available to repay bondholders on the maturity date. • Callable bonds permit bond issuers to pay off the principal before the maturity date. • Convertible bonds allow bondholders to convert their bonds into shares of common stock. 19 -25

TEST PREP • 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? 19 -26

BUYING SECURITIES LO 19 -5 • 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. 19 -27

MONEY GOING UP in SMOKE • You recently received news that your Uncle Alex passed away after a long battle with lung cancer caused by smoking. He left you $25, 000 in his will, saying you were his favorite nephew. • Your friend Jack recommends that you buy stock in a well-known multinational firm that is primary product is tobacco. • Will you invest your inheritance in a company that markets tobacco? 19 -28

FIVE INVESTMENT CRITERIA LO 19 -5 1. Investment risk 2. Yield 3. Duration 4. Liquidity 5. Tax consequences 19 -29

INVESTING 101 LO 19 -5 Things to Do Before Making Your First Investment • Take an investing class. • Attend a conference. • Head to the library and pick up investing books. Source: Money, www. money. com, accessed November 2014. 19 -30

AVERAGE ANNUAL RETURN of ASSET CLASSES (Since 1926) Investment Return Small company stocks 12. 2% Large company stocks 9. 5% Corporate bonds 6. 0% Long-term government bonds 5. 8% Treasury bills 4. 1% Source: Ibbotson Associates and Morningstar. LO 19 -5 19 -31

DIVERSIFICATION • LO 19 -5 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 19 -32

GLOBAL STOCKS: LOVE THEM or LEAVE THEM • Suggestions for building your financial future: - Invest in familiar global companies with a solid reputation and performance records. - Invest only in global stocks listed on U. S. exchanges. - Invest in global mutual funds that focus on specific countries or regions. - Use extreme caution if investing in unstable countries! 19 -33

PRIMARY INVESTMENT SERVICES CONSUMERS NEED LO 19 -5 • Savings and investing advice • Help with 401 k plans • Retirement planning • Tax planning • Estate planning • Education expense planning Source: Investment Company Institute. 19 -34

TEST PREP • What is the key advantage of investing through online brokers? What is the key disadvantage? • What is the primary purpose of diversifying investments? 19 -35

PERCEPTIONS of the MARKET LO 19 -6 • Bulls: Investors who believe stock prices are going to rise. • Bears: Investors who expect stock prices to decline. 19 -36

BEAR MARKET DECLINES in the S&P 500 Time Period % Drop in Prices 2007 -2009 52. 5% 2000 -2002 51% 1973 -1974 48. 2% 1968 -1970 36. 1% 1987 -1988 33. 5% Source: Stock Traders Almanac 2011. LO 19 -6 19 -37

SELECTING STOCKS LO 19 -6 • 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 19 -38

STOCK SPLITS LO 19 -6 • 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. 19 -39

BUYING STOCK on MARGIN LO 19 -6 • Buying Stock on Margin -- Borrowing some of the stock’s purchase cost from the brokerage firm. • 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. 19 -40

UNDERSTANDING STOCK QUOTATIONS LO 19 -6 19 -41

TOP FINANICIAL NEWS and RESEARCH SITES LO 19 -6 • Yahoo Finance • Daily. Finance • MSN Money • Forbes • Dow Jones & Co. 19 -42

IMPORTANT BOND QUESTIONS LO 19 -7 • 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. 19 -43

UNDERSTANDING BOND QUOTATIONS LO 19 -7 19 -44

INVESTING in MUTUAL FUNDS and EXCHANGE-TRADED FUNDS LO 19 -8 • 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. 19 -45

WHAT MUTUAL FUNDS CAN LEARN FROM Ka. Ching LO 19 -8 1. Reform the ratings system 2. Give information for free 3. Cut out useless fees 4. Be transparent 5. Share insights Source: Fast Company, www. fastcompany. com, accessed November 2014. 19 -46

PERCENTAGE of HOUSEHOLDS OWNING MUTUAL FUNDS Year % of Households 1980 5% 1990 24% 2000 43% 2005 42% 2010 48% Source: Investment Company Institute Factbook. LO 19 -8 19 -47

VARIETIES of ETFs ETF Traditional Description Most common; include large U. S. stocks, small U. S. stocks, international stocks, or investmentgrade bonds. Niche Focus on an individual sector like healthcare, high-yield bonds, or a single country. Exotic Invest in unusual, more volatile sectors such as commodities like gold and concepts like clean technology. Source: Schwab and E*Trade. LO 19 -8 19 -48

UNDERSTANDING MUTUAL FUND QUOTATIONS LO 19 -8 19 -49

COMPARING INVESTMENTS LO 19 -8 19 -50

TEST PREP • 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? 19 -51

The DOW LO 19 -9 19 -52

KEY STOCK MARKET INDICATORS LO 19 -9 • 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. 19 -53

MARKET TURMOIL LO 19 -9 • The stock market has its shares of ups and downs: - 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. 19 -54

TURMOIL in the 2000 s LO 19 -9 • 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 reenergize the economy. 19 -55

The WALL STREET of NOW Then LO 19 -9 Now Town Car Transportation Uber 21 Club Restaurant Subway The Penthouse Club After Hours Dave & Buster’s Johnny Walker Blue ($200) Drink Bud Light ($5) American Express Black Card Metrocard Bottle Service Pastime Trivia Night Source: Bloomberg Businessweek, www. businessweek. com, accessed November 2014. 19 -56

The UPS and DOWNS of the MARKET LO 19 -9 • Program Trading -- Giving instructions to computers to automatically sell if the price of a stock dips to a certain point to avoid potential losses. • Analysts believe program trading caused the turmoil in 1987. • The exchanges created mechanisms to restrict program trading. 19 -57

WHO’S at FAULT for the ECONOMIC CRISIS? LO 19 -9 • Wall Street - Issued exotic securities; paid excessive compensation based on bonuses; and investment banks got the SEC to relax capital requirements. • Main Street - Americans lived beyond their means; lenders gave favorable loans to homebuilders; greedy homeowners took out equity loans; and teaser mortgage rates let people live large. • Washington - Gramm-Leach-Billey Act allowed commercial and investment banks to partner; housing interest rates were kept low; and Community Reinvestment Act forced lending to people with bad credit. Source: Fortune Magazine, www. fortune. com, accessed November 2014. 19 -58

CLEANING UP the STREET LO 19 -9 19 -59

TEST PREP • 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. 19 -60