17. Calculate current yield, conversion ratio, and yield to maturity. A 6 percent convertible
bond (maturing in 20 years) is convertible into 25 shares of the company’s common stock.
The bond has a par value of $1,000 and is currently trading at $800; the stock (which pays
a dividend of 95 cents a share) is currently trading in the market at $35 a share. Use this
information to answer the following questions:
a. What is the current yield on the convertible bond? What is the dividend yield on the
company’s common stock? Which provides more current income: the convertible bond or
the common stock? Explain.
Current yield on the convertible bond is 7.5% ($60 / $800).
b. What is the bond’s conversion ratio?
The conversion ratio is 25, the number of shares that would be received per bond held.
c. What is the conversion value of this issue? Is there any conversion premium in this issue?
If so, how much?
Conversion value, the value of the conversion feature, is the conversion ratio of the issue
multiplied by the current market price of the underlying common stock. Here the conversion
value is 25 * $35 = $875.
18. Clean and dirty bond prices. You have decided to sell a 5 percent semiannual coupon
bond 2 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?
The dirty (full) price of the bond is the market price plus any accrued interest. Interest of $25 is
c. Explain how the clean and dirty prices of the bond are relevant to the buyer of the bond.
Interest is earned with the passing of time. The seller will expect to be paid for their earned
Critical Thinking Cases
12.1 The Matthew’s Problem: What to Do with “Extra” Money?
A couple in their early 30s, Leah and Eric Mathews recently inherited $90,000 from a
relative. Eric earns a comfortable income as a sales manager for Atmospheric Instruments,
Critical Thinking Questions
1. What kind of investment approach do you think the Matthews should adopt—that is,
should they be conservative with their money or aggressive? Explain.
The Matthews do not have a specific goal that they are investing to reach. Also, they do not
2. What kind of stocks do you think the Matthews 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 suggest some utility stock and health care stock. If they are
3. Construct an investment portfolio that you feel would be right for the Matthews 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 Matthews. Make sure that the portfolio consists of six or
more different securities and use 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 Matthews’ 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 Stephanie Explores Investing
Stephanie Fox is a 28-year-old management trainee at a large chemical company. She is
single, has an annual salary of $75,000 (placing her in the 22 percent tax bracket), and her
monthly expenditures come to approximately $3,500. During the past year or so, Stephanie
has managed to save around $11,000, and she expects to continue saving at least that
amount each year for the foreseeable future. Her company pays the premium on her
Critical Thinking Questions
1. What investment options are open to Stephanie?
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 $30,000 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
market. Accordingly, she can expect about 8% over long term in a slow and steady progression.
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 Stephanie 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
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.
2. Financial risk concerns the amount of debt used to finance a firm, as well as the possibility
that the firm will not have sufficient cash flows to meet these obligations on time.
12-2 What is meant by the risk-return trade-off? What is the risk-free rate of return?
The amount of risk associated with a given investment vehicle is directly related to its expected
return. This universal rule of investing means that if you want a higher level of return, you’ll
probably have to accept greater exposure to risk. This is the risk-return trade-off.
12-3 Briefly describe the two basic sources of return to investors.
Any investment vehicle—whether it’s a share of stock, a bond, a piece of real estate, or a mutual
fund—has just two basic sources of return: current income and capital gains.
12-4 What is interest on interest, and why is it such an important element of return?
If your investment program generates interest income, such as interest on bonds, it is important
to reinvest the interest rather than consuming it. Otherwise, the value of your investments will
12-5 What is the required rate of return, and how would it be used to make an investment
decision?
The value of any investment depends on the amount of return that it’s expected to provide
relative to the amount of perceived risk involved. The required rate is the minimum rate of
12-6 From a tax perspective, would it make any difference to an investor whether the
return on a stock took the form of dividends or capital gains? Explain.
Historically yes it mattered. However, for tax years beginning after 2012, qualified dividends
[basically those from domestic corporations and qualified foreign corporations] are taxed at 20%
12-7 What’s the difference between a cash dividend and a stock dividend? Which would
you rather receive?
Cash dividends are paid to the stockholder in cash and are taxable at the capital gains rate. Stock
dividends paid to the shareholder in stock and are generally non-taxable. Stock dividends have
12-8 Define and briefly discuss each of these common stock measures: (a) book value, (b)
ROE, (c) EPS, (d) P/E ratio, and (e) beta.
The amount of stockholders’ equity [assets minus liabilities minus preferred stock] in a firm is
measured by book value. Book value indicates the amount of stockholder funds used to finance
the firm.
12-9 Briefly discuss some of the different types of common stock. Which types would be
most appealing to you, and why?
1. blue-chip stock A stock generally issued by companies expected to provide an uninterrupted
stream of dividends and good long-term growth prospects.
2. growth stock A stock whose earnings and market price have increased over time at a rate that
is well above average.
12-10 Summarize the evidence on the potential cost of being out of the stock market during
its best months.
A common myth: During volatile markets, it makes sense to sell your stocks and wait for
12-11 Describe the dollar cost averaging strategy. Explain whether it is better to invest in a
single lump sum or to spread the investment out over time.
Dollar cost averaging is the investment strategy of purchasing an equal dollar amount of stocks
at equal intervals over time. The underlying rationale for the strategy is that you’ll average out
12-12 What are DRPs, and how do they fit into a stock investment program?
The investment philosophy at work with a dividend reinvestment plan (DRP) is this: if the
company is good enough to invest in, then it’s good enough to reinvest in. In a DRP,
12-14 What’s the difference between a secured bond and an unsecured bond?
Secured bonds have specific assets as collateral for the bond. In effect, it is like a mortgage.
12-15 Are junk bonds and zero coupon bonds the same? Explain. What are the basic tax
features of a tax-exempt municipal bond?
Zero coupon bonds, as the name implies, are bonds issued without coupons. To compensate for
their lack of coupons, that is interest, these bonds are sold at a deep discount from their par
values and then increase in value over time, at a compound rate of return, so at maturity they’re
worth much more than their initial investment. Other things being equal, the cheaper the bond,
the greater the return you can earn.
12-16 What is a convertible bond, and why do investors buy convertible securities?
The convertible bond, found only in the corporate market, is a type of hybrid security because
they possess the features of both corporate bonds and common stocks. That is, though they’re
12-17 Describe the conversion privilege on a convertible security. Explain how the market
price of the underlying common stock affects the market price of a convertible bond.
The key element of any convertible issue is its conversion privilege, which describes the
12-18 Explain the system of bond ratings used by Moody’s and Standard & Poor’s. Why
would it make sense to ever buy junk bonds?
Bond ratings are like grades: A letter grade is assigned to a bond, which designates its
12-19 Explain the difference between dirty (full) and clean bond prices? What is the
significance of the difference in the prices for a bond buyer?
In market jargon, how accrued interest is treated in bond pricing is the basis for the distinction
12-20 What effects do market interest rates have on the price behavior of outstanding
bonds?
If the interest rate goes up, the bond value goes down. The interest that will be paid is set by the
terms of the bond, thus, a change in the market rate does not change the amount of interest that
will be paid. The only way to adjust to the market rate is to adjust the price of the bond.
Key Terms
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.
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
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
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.
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.
The difference between a convertible security’s market price and its
conversion value.
cyclical stock
Stock whose price movements tend to parallel the various stages of the
business cycle.
debenture
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.
An unsecured bond issued on the general credit of the firm.
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
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
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
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
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.
A stock whose total market value falls somewhere between $2 billion
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.
required rate
of return
The minimum rate of return an investor feels should be earned in
compensation for the amount
return on equity
(ROE)
A measure that captures the firm’s overall profitability; it is important
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-
A stock with a total market value of less than $2 billion.
cap stock
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
indexed bond
adjusted to provide protection again inflation as measured by the
yield to maturity
The fully compounded rate of return that a bond would yield if it were
zero coupon bond
A bond that pays no annual interest but sells at a deep discount to its
A bond issued and backed up by the full faith and credit of the U.S.
Investing in Stocks and Bonds
Chapter Outline
Learning Objectives
I. The Risks and Rewards of Investing
A. The Risks of Investing
1. Business Risk
2. Financial Risk
3. Market Risk
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
D. Types of Common Stock
1. Blue-Chip Stocks
G. Making the Investment Decision
1. Putting a Value on Stock
2. Timing Your Investments
3. Be Sure to Plow Back Your Earnings
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
Personal Choices