Investing in Stocks
and Bonds
Chapter 12
How Will This Affect Me?
Once you’ve figured out how much you need to invest to meet important financial goals, it’s
time to decide which specific investments to buy. This chapter describes the basic characteristics
of stocks and bonds, explains their potential returns and risks, and provides a framework for
choosing among stocks and bonds to meet your financial objectives. Care is taken to explore how
stock and bond prices behave and how to evaluate their performance over time. After reading
this chapter you should be able to choose the most appropriate stocks and bonds for your
portfolio in light of your goals and constraints.
You will need to spend some time with this chapter. If you assign and go over several of the
homework problems, it will take 4 or 5 50-minutes classes. As I said at the beginning of Chapter
11, this is important material and is worth the time.
The material in this chapter is best learned in a hands-on exercise. As suggested in Chapter 11,
some investing game would help make the concepts here real. Perhaps the game could be played
over a longer period as part of an investment club. Perhaps prizes could be awarded for the best
performance. Maybe even a scholarship for next semester or graduate study could be offered.
Alumni could be involved by meeting with the students occasionally to comment on what they
are doing.
If not the above, assign the Financial Planning Exercises which ask the student to make
investment decisions.
Learning Objectives
12–1 Describe the various types of risks to which investors are exposed, as well as the sources of
return.
12-2 Know how to search for an acceptable investment on the basis of risk, total return, and
yield.
12-3 Discuss the merits of investing in common stock and be able to distinguish among the
different types of stocks.
12-4 Become familiar with the various measures of performance and how to use them in placing
a value on stocks.
12-5 Describe the basic issue characteristics of bonds, as well as how these securities are used as
investment vehicles.
12-6 Distinguish between the different types of bonds, gain an understanding of how bond prices
behave, and know how to compute different measures of yield.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre–test questions” to get their attention.
• Income stocks have relatively high dividend yields and, as such, appeal to individuals
who seek a high level of current income.
Fact: Income shares are have a long and sustained record of regularly paying a much
higher than average level of dividends. Because of this, they are highly sought after by
investors seeking a safe and steady source of current income.
Fact: Convertible bonds carry the provision that they may, within a stipulated time
period, be converted into a certain number of shares of the issuing company’s common
stock.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
1. True False You would have to save $2,500 a year in order to end up with a
$25,000 nest egg in ten years.
2. True False A good investment is one that offers a positive rate of return.
3. True False Income stocks have relatively high dividend yields and, as such,
appeal to individuals who seek a high level of current income.
4. True False Putting your money into stocks that offer dividend reinvestment
plans is a great way of building up your investment capital.
5. True False When interest rates go down, bond prices also go down because
such securities become less valuable.
6. True False Convertible bonds are so named because they can be exchanged
for a set number of shares of common stock.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
YOU CAN DO IT NOW
What’s the Market P/E Ratio Telling You?
YOU CAN DO IT NOW
What’s the Market P/E Ratio Telling You?
YOU CAN DO IT NOW
How Do Stock and Bond Market Returns Compare This Year?
How Do Stock and Bond Market Returns Compare This Year?
Financial Impact of Personal Choices
Read and think about the choices being made. Do you agree or not? Ask the students to discuss
the choices being made.
Lucy and Ted Like High Flying Stocks
Lucy and Ted Richardson are both 33 years old and invest 15 percent of their after-tax
annual income in stocks. They hate missing out on great returns when the stock of a
company doing great things starts going through the roof. For example, Lucy and Ted
feel they should have invested in Activision Blizzard in 2017 when it earned almost an
80 percent return! So any time a company they know well earns more than 20 percent
in a year, they try to invest in it. And because they believe in the stocks they buy, the
Richardsons always hold their stocks until they at least break even. What do you make
of the Richardsons’ approach to stock investing?
Financial Planning Exercises
1. Ranking investments by expected returns. What makes for a good investment? Use the
approximate yield formula or a financial calculator to rank the following investments
according to their expected returns.
a. Buy a stock for $30 a share, hold it for three years, and then sell it for $60 a share (the
stock pays annual dividends of $2 a share).
b. Buy a security for $40, hold it for two years, and then sell it for $100 (current income on
this security is zero).
c. Buy a one-year, 5 percent note for $1,000 (assume that the note has a $1,000 par value
and that it will be held to maturity).
2. Calculating expected return on investment. An investor is thinking about buying some
shares of Health Diagnostics, Inc., at $75 a share. She expects the price of the stock to rise
to $115 a share over the next three years. During that time, she also expects to receive
annual dividends of $4 per share. Assuming that the investor’s expectations (about the
future price of the stock and the dividends it pays) hold up, what rate of return can the
investor expect to earn on this investment? (Hint: Use either the approximate yield formula
or a financial calculator to solve this problem.)
3. Calculating expected return on a stock. The price of Outdoor Designs, Inc. is now $85.
The company pays no dividends. Fred Gray expects the price four years from now to be
$125 a share. Should Fred buy Outdoor Designs if he wants a 15 percent rate of return?
Explain.
4. Calculating key stock performance metrics. The Castle Company recently reported net
profits after taxes of $15.8 million. It has 2.5 million shares of common stock outstanding
and pays preferred dividends of $1 million a year. The company’s stock currently trades at
$60 per share.
a. Compute the stock’s EPS.
b. What is the stock’s P/E ratio?
c. Determine what the stock’s dividend yield would be if it paid $1.75 per share to common
stockholders.
5. Choosing appropriate stocks. Assume that you’ve just inherited $500,000 and have
decided to invest a big chunk of it ($350,000, to be exact) in common stocks. Your objective
is to build up as much capital as you can over the next 15 to 20 years, and you’re willing to
tolerate a “good deal’’ of risk.
6. Calculating and interpreting current yield and yield to maturity. Find the current yield
of a 5.65 percent, 8-year bond that’s currently priced in the market at $853.75. Now, use a
financial calculator to find the yield to maturity on this bond (use annual compounding).
What’s the current yield and yield to maturity on this bond if it trades at $1,000? If it’s
priced at $750? Comment on your findings.
Quote
Current Yield
Yield to Maturity
Using Financial Calculator
5.65%, 8 yr., $853.75
$56.5/$853.75 =
6.62%%
853.75 +/– PV
1000 FV
56.5/2 PMT
8 × 2 N
CPT I/Y 4.09% * 2 = 8.18%
5.65%,8yr, $1,000
$56.5 / $1,000 =
5.65%
1000 +/– PV
1000 FV
56.5/2 PMT
8 × 2 N
CPT I/Y 2.83% * 2 = 5.66%
5.65%, 8 yr., $750
$56.5 / 750 = 7.53%
750 +/– PV
1000 FV
56.5/2 PMT
8 × 2 N
CPT I/Y 5.16% * 2 = 10.32%
Investopedia has a yield to maturity calculator at
https://www.investopedia.com/calculator/aoytm.aspxhttps://www.investopedia.com/calculator/ao
ytm.aspx.
It is simple to use.
7. Tax treatment of bond returns. An investor in the 22 percent tax bracket is trying to
decide which of two bonds to select: one is a 5.5 percent U.S. Treasury bond selling at par;
the other is a municipal bond with a 4.25 percent coupon, which is also selling at par.
Which of these two bonds should the investor select? Why?
8. Calculating current yield and yield to maturity. Describe and differentiate between a
bond’s (a) current yield and (b) yield to maturity. Why are these yield measures important
to the bond investor? Find the yield to maturity of a 20-year, 9 percent, $1,000 par value
bond trading at a price of $850. What’s the current yield on this bond?
9. Calculating and comparing current yields. Which of these two bonds offers the highest
current yield? Which one has the highest yield to maturity?
a. A 6.55 percent, 22-year bond quoted at 52.000
b. A 10.25 percent, 27-year bond quoted at 103.625
10. Clean and dirty bond prices. You have decided to sell a 5 percent semiannual coupon
bond two months after the last coupon payment. The bond is currently selling for $951.25.
Answer the following questions about the bond:
a. What is the clean price of the bond?
b. What is the dirty (full) price of the bond?
c. Explain how the clean and dirty prices of the bond are relevant to the buyer of the bond.
Test Yourself
12-1 Describe the various types of risk to which investors are exposed.
1. Business risk is the variability surrounding the firm’s cash flows and subsequent ability to
meet operating expenses on time.
12-2 What is meant by the risk-return trade-off? What is the risk-free rate of return?
12-3 Briefly describe the two basic sources of return to investors.