Criterial Thinking Cases
12.1 The Madsen’s Problem: What to Do with All That Money?
A couple in their early 30s, Rodney and Carly Madsen recently inherited $90,000 from a
relative. Charles earns a comfortable income as a sales manager for System Analytics, Inc.,
and Carly does equally well as an attorney with a major law firm. Because they have no
children and don’t need the money, they’ve decided to invest all of the inheritance in
stocks, bonds, and perhaps even some money market instruments. However, because
they’re not very familiar with the market, they turn to you for help.
Critical Thinking Questions
1. What kind of investment approach do you think the Madsen should adopt—that is,
should they be conservative with their money or aggressive? Explain.
The Madsens do not have a specific goal that they are investing to reach. Also, they do not
appear to want to spend time managing the investments. They also only have $90,000 so a wide
array of stock portfolio is not feasible. While it is the topic of chapter 13, I would suggest two
If they want to spend some time investing the funds, they can select three so stocks and buy and
2. What kind of stocks do you think the Madsen should invest in? How important is current
income (i.e., dividends or interest income) to them? Should they be putting any of their
money into bonds? Explain.
As above, if they invest in stocks, I would suggest some utility stock and health care stock.
3. Construct an investment portfolio that you feel would be right for the Madsen and invest
the full $90,000. Put actual stocks, bonds, and/or convertible securities in the portfolio; you
may also put up to one-third of the money into short-term securities such as CDs, Treasury
bills, money funds, or MMDAs. Select any securities you want, so long as you feel they’d be
suitable for the Madsen. Make sure that the portfolio consists of six or more different
securities, and use the latest issue of The Wall Street Journal or an online source such as
http://finance.yahoo.com to determine the market prices of the securities you select. Show
the amount invested in each security along with the amount of current income (from
dividends and/or interest) that will be generated from the investments. Briefly explain why
you selected these particular securities for the Madsen’ portfolio.
The students like many investors, will most likely look at the past returns and assume they will
continue in the future. It would be great if the students could have the opportunity to invest part
12.2 Natasha Explores Investing
Natasha Cormier is a 28-year–old management trainee at a large chemical company. She is
single, has an annual salary of $34,000 (placing her in the 15 percent tax bracket), and her
monthly expenditures come to approximately $1,500. During the past year or so, Natasha
has managed to save around $8,000, and she expects to continue saving at least that amount
each year for the foreseeable future. Her company pays the premium on her $35,000 life
insurance policy. Because Natasha’s entire education was financed by scholarships, she was
able to save money from the summer and part-time jobs she held as a student. Altogether,
she has a nest egg of nearly $18,000, out of which she’d like to invest about $15,000. She’ll
keep the remaining $3,000 in a bank CD that pays 3 percent interest and will use this
money only in an emergency. Natasha can afford to take more risks than someone with
family obligations can, but she doesn’t wish to be a speculator; she simply wants to earn an
attractive rate of return on her investments.
Critical Thinking Questions
1. What investment options are open to Natasha?
Growth stocks, small caps, and perhaps tech stocks are the type of securities that fits her
2. What chance does she have of earning a satisfactory return if she invests her $15,000 in
(a) bluechip stocks, (b) growth stocks, (c) speculative stocks, (d) corporate bonds, or (e)
municipal bonds?
a. Bluechips have been around for a long time and may be expected to follow the general
b. Growth stocks is like “those men in their flying machines”, they will go up and they will go
c. Speculative stocks are not for an investor with only $15,000. The chance of loss is too great
d. Corporate bonds will yield a slow and steady return, likely just below the stock market as a
e. Municipal bonds are advantageous to taxpayers in the highest bracket. She is not there yet so
3. Discuss the factors you would consider when analyzing these alternate investment
vehicles.
The driving force is her risk tolerance. Stocks are volatile, that is their price will go up and
4. What recommendation would you make to Natasha regarding her available investment
alternatives? Explain.
As in part 1, I would urge her to put money in a retirement fund and invest in growth stock and
smallcap stock. Both of these have potential for appreciation. With her low tax rate [15%] long-
Terms Found in the Chapter
accrued interest The amount of interest that’s been earned since the last coupon
payment date by the bond holder/seller, but which will be received by
the new owner/buyer of the bond at the next regularly scheduled
coupon payment date.
agency bond An obligation of a political subdivision of the U.S. government.
beta
.
An index of the price volatility for a share of common stock; a
reflection of how the stock price responds to market forces.
blue-chip stock A stock generally issued by companies expected to provide an
uninterrupted stream of dividends and good long-term growth
prospects.
book value The amount of stockholders’ equity in a firm; determined by
subtracting the company’s liabilities and preferred stock from its assets.
business risk The variability associated with a firm’s cash flows and with its
subsequent ability to meet its operating expenses on time.
call feature Bond feature that allows the issuer to retire the security prior to
maturity.
clean price The quoted price of a bond, which understates the true price of a bond
by any accrued interest.
conversion
premium
The difference between a convertible security’s market price and its
conversion value.
conversion
privilege
The provision in a convertible issue that stipulates the conditions of the
conversion feature, such as the conversion period and conversion ratio.
conversion ratio A ratio specifying the number of shares of common stock into which a
convertible bond can be converted.
conversion value A measure of what a convertible issue would trade for if it were priced
to sell based on its stock value.
corporate bond A bond issued by a corporation.
coupon Bond feature that defines the annual interest income the issuer will pay
the bondholder.
current yield
.
The amount of current income a bond provides relative to its market
price.
cyclical stock Stock whose price movements tend to parallel the various stages of the
business cycle.
debenture An unsecured bond issued on the general credit of the firm.
defensive stock Stock whose price movements are usually contrary to movements in
the business cycle.
discount bond A bond whose market value is lower than par.
dirty (full) price The quoted price of a bond plus accrued interest, the total of which is
the relevant price to be paid by a bond buyer.
dividend
reinvestment
plan (DRP)
A program whereby stockholders can choose to take their cash
dividends in the form of more shares of the company’s stock.
dividend yield The percentage return provided by the dividends paid on common
stock.
earnings per share
(EPS)
The return earned by each share of common stock; calculated by
dividing all earnings remaining after paying preferred dividends by
the number of common shares outstanding.
equipment trust
certificate
A bond secured by certain types of equipment, such as railroad cars and
airplanes.
event risk The risk that some major, unexpected event will occur that leads to a
sudden and substantial change in the value of an investment.
financial risk A type of risk associated with the amount of debt used to finance the
firm and its ability to meet these obligations on time.
fixed-income
securities
Securities such as bonds, notes, and preferred stocks that offer
purchasers fixed periodic income
fully taxable
equivalent yield
The return that a fully taxable bond must provide in order to match the
after-tax return on a lower-yielding tax-free bond.
general obligation
bond
A municipal bond backed by the full faith and credit of the issuing
municipality.
growth stock A stock whose earnings and market price have increased over time at a
rate that is well above average.
junk bond Also known as high-yield bonds, these are highly speculative securities
that have received low ratings from Moody’s or Standard & Poor’s.
income stock A stock whose appeal is the dividends it pays out; offers dividend
payments that can be expected to increase over time.
interest rate risk A type of risk, resulting from changing market interest rates, that
mainly affects fixed-income securities.
large-cap stock A stock with a total market value of more than $10 billion.
liquidity risk A type of risk associated with the inability to liquidate an investment
conveniently and at a reasonable price.
market risk A type of risk associated with the price volatility of a security.
mid-cap stock A stock whose total market value falls somewhere between $2 billion
and $10 billion.
mortgage-backed
securities
Securities that are a claim on the cash flows generated by mortgage
loans; bonds backed by mortgages as collateral.
municipal bond A bond issued by state or local governments; interest income is usually
exempt from federal taxes.
mortgage bond A bond secured by a claim on real assets, such as a manufacturing
plant.
net profit margin A key measure of profitability that relates a firm’s net profits to its
sales; shows the rate of return the company is earning on its sales.
premium bond A bond whose market value is higher than par.
price/earnings
(P/E)
ratio
A measure of investors’ confidence in a given security; calculated by
dividing market price per share by EPS.
proxy A written statement used to assign a stockholder’s voting rights to
another person, typically one of the directors.
purchasing power
risk
A type of risk, resulting from possible changes in price levels, that can
significantly affect investment returns.
residual owners Shareholders of the company; they are entitled to dividend income and
a share of the company’s profits only after all of the firm’s other
obligations have been met.
return on equity
(ROE)
A measure that captures the firm’s overall profitability; it is important
because of its impact on the firm’s growth, profits, and dividends.
required rate
of return
The minimum rate of return an investor feels should be earned in
compensation for the amount
revenue bond
.
A municipal bond serviced from the income generated by a specific
project
risk-free rate
of return
The rate of return on short-term government securities, such as
Treasury bills, that is free from any type of risk.
serial obligation An issue that is broken down into a series of smaller bonds, each with
its own maturity date and coupon rate.
sinking fund A bond provision specifying the annual repayment schedule to be used
in paying off the issue.
small-
cap stock
A stock with a total market value of less than $2 billion.
speculative stock Stock that is purchased on little more than the hope that its price per
share will increase.
stock dividends New shares of stock distributed to existing stockholders as a
supplement to or substitute for cash dividends.
tech stock A stock that represents the technology sector of the market.
Treasury bond A bond issued and backed up by the full faith and credit of the U.S.
government.
Treasury inflation-
indexed bond
A bond, issued by the U.S. government, whose principal payments are
adjusted to provide protection again inflation as measured by the
Consumer Price Index (CPI).
yield to maturity The fully compounded rate of return that a bond would yield if it were
held to maturity.
zero coupon bond A bond that pays no annual interest but sells at a deep discount to its
par value.
Investing in Stocks and Bonds
Chapter Outline
Learning Goals
I. The Risks and Rewards of Investing
A. The Risks of Investing
1. Business Risk
2. Financial Risk
3. Market Risk
4. Purchasing Power Risk
5. Interest Rate Risk
6. Liquidity Risk
7. Event Risk
B. The Returns from Investing
1. Current Income
2. Capital Gains
3. Earning Interest on Interest: Another Source of Return
C. The Risk-Return Trade-of
D. What Makes a Good Investment?
1. Future Return
2. Approximate Yield
*Test Yourself*
II. Investing in Common Stock
A. Common Stocks as a Form of Investing
1. Issuers of Common Stock
2. Voting Rights
3. Basic Tax Considerations
B. Dividends
C. Some Key Measures of Performance
1. Book Value
2. Net Pro9t Margin
3. Return on Equity
4. Earnings per Share
5. Price/Earnings Ratio
6. Beta
D. Types of Common Stock
1. Blue-Chip Stocks
2. Growth Stocks
3. Tech Stocks
4. Income Stocks versus Speculative Stocks
5. Cyclical Stocks or Defensive Stocks
6. Large-Caps, Mid-Caps, and Small-Caps
E. Market Globalization and Foreign Stocks
F. Investing in Common Stock
1. Advantages and Disadvantages of Stock Ownership
G. Making the Investment Decision
1. Putting a Value on Stock
2. Timing Your Investments
3. Be Sure to Plow Back Your Earnings
*Test Yourself*
III. Investing in Bonds
A. Why Invest in Bonds?
B. Bonds versus Stocks
C, Basic Issue Characteristics
1. Types of Issues
2. Sinking Fund
3. Call Feature
D. The Bond Market
1. Treasury Bonds
2. Agency and Mortgage-Backed Bonds
3. Municipal Bonds
4. Corporate Bonds
5. The Special Appeal of Zero Coupon Bonds
6. Convertible Bonds
E. Bond Ratings
F. Pricing a Bond
1. Bond Prices and Accrued Interest
2. Bond Prices and Yields
3. Current Yield and Yield to Maturity
*Test Yourself*
Summary
Financial Planning Exercises
Applying Personal Finance
What’s Your Type?
Critical Thinking Cases
12.1 The Madsen’ Problem: What to Do with All That Money?
12.2 Natasha Explores Investing
Money Online!