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Chapter 19 Using Securities Markets for Financing and Investing Opportunities McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Nineteen LEARNING GOALS 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 Chapter Nineteen LEARNING GOALS 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 Profile MARIA BARTIROMO CNBC • Emmy Award-winning journalist, Bartiromo’s analysis of day-to-day Wall Street has made her the face of investing. • Started as an overnight producer for CNN before moving to CNBC. • She’s lead anchor at two of CNBC’s biggest shows, has written several books and numerous columns. 19-4 The Function of Securities Markets LG1 The BASICS of SECURITIES MARKETS • 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. 19-5 The Function of Securities Markets LG1 TYPES of SECURITIES MARKETS • 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. 19-6 The Role of Investment Bankers LG1 INVESTMENT BANKERS and INSTITUTIONAL INVESTORS • 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. 19-7 Stock Exchanges STOCK EXCHANGES LG2 • 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. 19-8 Stock Exchanges TOP STOCK EXCHANGES LG2 • NYSE Euronext • NASDAQ • London Stock Exchange • Tokyo Stock Exchange • Deutsche Borse 19-9 Securities Regulations and the SEC LG2 The SECURITIES and EXCHANGE COMMISSION • 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. 19-10 How Businesses Raise Capital by Selling Stock LG3 LEARNING the LANGUAGE of STOCKS • 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. 19-11 Advantages & Disadvantages of Issuing Stock LG3 ADVANTAGES of ISSUING STOCK • 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. 19-12 Advantages & Disadvantages of Issuing Stock LG3 DISADVANTAGES of ISSUING STOCK • 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. 19-13 Issuing Shares of Common and Preferred Stock TWO CLASSES of STOCK LG3 • 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 19-14 Learning the Language of Bonds LG4 LEARNING the LANGUAGE of BONDS • 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. 19-15 Advantages & Disadvantages of Issuing Bonds LG4 ADVANTAGES of ISSUING BONDS • 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. 19-16 Advantages & Disadvantages of Issuing Bonds LG4 DISADVANTAGES of ISSUING BONDS • 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. 19-17 Advantages & Disadvantages of Issuing Bonds BOND RATINGS LG4 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 19-18 Different Classes of Bonds LG4 DIFFERENT CLASSES of CORPORATE BONDS • 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). 19-19 Special Bond Features LG4 SPECIAL FEATURES in BOND ISSUES • 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. 19-20 How Investors Buy Securities LG5 BUYING SECURITIES • 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. 19-21 Choosing the Right Investment Strategy FIVE INVESTMENT CRITERIA LG5 1. Investment risk 2. Yield 3. Duration 4. Liquidity 5. Tax consequences 19-22 Choosing the Right Investment Strategy LG5 INVESTING 101 Things to Do Before Making Your First Investment • Take an investing class. • Attend a conference. • Head to the library and pick up these books: - The Big Short - The Intelligent Investor - The Myth of the Rational Market Source: Money, November 2010. 19-23 Reducing Risk by Diversifying Investments DIVERSIFICATION LG5 • 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 19-24 Reducing Risk by Diversifying Investments LG5 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. 19-25 Investing in Stocks PERCEPTIONS of the MARKET LG6 • Bulls: Investors who believe stock prices are going to rise. • Bears: Investors who expect stock prices to decline. 19-26 Investing in Stocks SELECTING STOCKS LG6 • 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 19-27 Stock Splits STOCK SPLITS LG6 • 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. 19-28 Buying Stock on Margin BUYING STOCK on MARGIN LG6 • 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. 19-29 Understanding Stock Quotations LG6 TOP FINANICIAL NEWS and RESEARCH SITES • Yahoo Finance • DailyFinance • MSN Money • Forbes • Dow Jones & Co. 19-30 Investing in Bonds IMPORTANT BOND QUESTIONS LG7 • 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. 19-31 Investing in Mutual Funds & ExchangeTraded Funds LG8 INVESTING in MUTUAL FUNDS and EXCHANGE-TRADED FUNDS • 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. 19-32 Investing in Mutual Funds & ExchangeTraded Funds LG8 WHAT MUTUAL FUNDS CAN LEARN FROM KaChing 1. Reform the ratings system 2. Give information for free 3. Cut out useless fees 4. Be transparent 5. Share insights Source: Fast Company, March 2010. 19-33 Understanding Mutual Fund Quotations COMPARING INVESTMENTS LG8 19-34 Understanding Stock Market Indicators LG9 KEY STOCK MARKET INDICATORS • 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. 19-35 Riding the Market’s Roller Coaster MARKET TURMOIL LG9 • 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. 19-36 Riding the Market’s Roller Coaster TURMOIL in the 2000s LG9 • 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. 19-37 Riding the Market’s Roller Coaster LG9 The UPS and DOWNS of the MARKET • 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. 19-38 Riding the Market’s Roller Coaster LG9 WHO’S at FAULT for the ECONOMIC CRISIS? • 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 July 2011. 19-39 CLEANING UP the STREET (Legal Briefcase) • 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. 19-40