CHAPTER 19 – USING SECURITIES MARKETS FOR FINANCING AND
LEARNING GOALS:
After you have read and studied this chapter you should be able to:
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.
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.
Listed below are important terms found in the chapter. Choose the correct term for the definition and write it in the space provided.
Bond |
Institutional investors |
Program trading |
Buying stock on margin |
Interest |
Prospectus |
Capital gains |
Investment bankers |
Securities and Exchange Commission (SEC) |
Common stock |
Junk bonds |
Sinking fund |
Debenture bond |
Maturity date |
Stockbroker |
Diversification |
Mutual fund |
Stock certificate |
Dividends |
NASDAQ |
Stock exchange |
Dow Jones Industrial Average (the Dow) |
Over-the-counter market (OTC) |
Stocks |
Exchange traded funds (ETFs) |
Preferred stock |
Stock splits |
Initial public offering (IPO) |
|
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1. Large investors known as _____are organizations such as pension funds, mutual funds, insurance companies, and banks that invest their own funds or the funds of others.
2 The _is an exchange that provides a means to trade stocks not listed on national exchanges.
3. Evidence of stock ownership is called a ____ and specifies the name of the company, the number of shares it represents, and the type of stock being issued.
4. Trading known as ___ means giving instructions to computers to automatically sell if the price of stock dips to a certain point to avoid potential losses.
5. The most basic form of ownership in a firm is _, which confers voting rights and the right to share in the firm’s profits through dividends, if offered by the firm’s board of directors.
6. A ___ is a reserve account in which the issuer of a bond periodically retires some part of the bond principal prior to maturity so that enough capital will be accumulated by the maturity date to pay off the bond.
7. A registered representative who works as a market intermediary known as a __, buys and sells securities for clients.
8. An organization that is known as a ___ is one whose members can buy and sell securities for companies and investors.
9. The exact date the issuer of a bond must pay the principal to the bondholder is known as the _____.
10. Stock called _ gives its owner's preference in the payment of dividends and an earlier claim on assets than common stockholders if the business is forced out of business and its assets sold.
11. Specialists called assist in the issue and sale of new securities.
12. The payment the issuer of a bond makes to the bondholders to pay for the use of borrowed money is called __.
13. A ___is a bond that is unsecured (i.e. not backed by any collateral.)
14. The process of ____is the purchase of stocks by borrowing some of the purchase cost from the brokerage firm.
15. The part of a firm's profits that may be distributed to stockholders as either cash payments or additional shares of stock are called __.
16. A is an action by a company that gives stockholders two or more shares of stock for each one they own.
17. The technique of means buying several different investment alternatives to spread the risk of investing.
18. Shares of ownership in a company are called _.
19. A _is an organization that buys stocks and bonds and then sells shares in those securities to the public.
20. A corporate certificate called a _____ indicates that a person has lent money to a firm.
21. The average cost of 30 selected industrial stocks called the _ is used to give an indication of the direction of the stock market over time.
22. The _____ is the federal agency that has the responsibility for regulating the various exchanges.
23. A condensed version of economic and financial information called a ____ must be filed with the SEC before issuing stock; it must be sent to potential purchasers of the firm’s stock.
24. The ___is a nationwide electronic system that links dealers across the nation so that they can buy and sell securities electronically.
25. _____ are the positive differences between the purchase price of a stock and its sale price.
26. A (n) ___is the first public offering of a corporation’s stock.
28. Collections of stocks that are traded on exchanges are called ____, and are traded more like individual stocks than like mutual funds.
b. __
2. Explain the difference between the primary and the secondary markets
3. What functions do investment bankers perform for companies?
a. ____
b. ____
4. Give some examples of types of institutional investors
5. Describe the NYSE Euronext.
6. How does trading over the counter (OTC) differ from trading on the NYSE Euronext?
7. The NASDAQ is __
_____
8. How does the Securities Act of 1933 protect investors?
9. Discuss the provisions of the Securities and Exchange Act of 1934.
a. _
b. _
c. _
d. _
10. Insider trading is :
_____
The term “insider” includes: ___
_____
11. How is it possible for Americans to purchase stocks in foreign companies, and for foreigners to purchase stock in American companies?
12. What is meant by a stock’s par value?
13. Describe the important elements of dividends.
a. _____
b. _____
c. _____
14. List the advantages of raising funds through the sale of stock.
a.___
b.___
c.___
15. Describe the disadvantages of issuing stock.
a.___
b.___
c.___
16. What are three rights of holders of common stock?
a. _
b. _
c. _
17. What are the benefits of owning preferred stock?
a. _
b. _
18. Normally, preferred stockholders do not get__
Preferred stock is generally issued with a par value that becomes ____
_
19. The special features of preferred stock are that it can be:
b. __
c. __
20. What legal obligation does a company have when selling bonds?
21. What is meant by the term “principal” when referring to a bond?
22. If a $1,000 bond has an interest rate of 10% and a maturity date of 2030, what does that mean to a bondholder?
23. What is meant by the term “coupon rate” with regard to bonds?
24. What factors affect the interest rate of a bond? Can the rate of interest change, once it has been set?
25. List the advantages of raising long-term capital by selling bonds.
a. ___
b. ___
c. ___
d. ___
26. What are the disadvantages?
a. ___
b. ___
c. ___
27. Describe the two classes of corporate bonds.
28. Why are sinking funds attractive to firms and investors?
a. ___
b. ___
c. ___
29. What the characteristics of a callable bond, and what is the benefit to a company?
30. What are the features of a convertible bond, and why would an investor convert a bond to common stock?
31. What is the process for an individual to invest in stocks and bonds?
32. What is the benefit of trading on-line?
33. What kind of customers use online trading?
34. The first step in any investment program is to: ___
Other factors to consider are: _
___
35. Describe the five criteria to use when selecting an investment option.
a. _____
b. _____
c. _____
d. ___
e. ___
37. In the stock market, describe:
Bulls (and a bull market): _____
____
Bears (and a bear market): ____
___
38. According to the text, what determines the market price of a stock?
39. Describe:
_____
_____
_____
d. Penny stocks: ____
____
40. What is the difference between a market order and a limit order, when placing an order to buy stock?
41. What is the difference between a round lot and an odd lot?
42. Why would a company declare a stock split?
How does a two-for-one- stock split work?
How does a stock split benefit an investor?
43. What is a “margin”? What does a 50% margin rate mean?
44. What is the downside of buying on margin?
What is meant by the term “margin call”?
45. What information is included in a stock quote?
a. _____
b. _____
c. _____
d. _____
e. _____
Learning Goal 7
Investing in Bonds
46. What are the best investments for those who desire limited risk and guaranteed income?
47. What are two questions first time corporate bond investors may ask? What are the answers to the questions?
48. What does it mean to sell a bond:
at a discount?
at a premium?
49. Why are junk bonds considered “junk”?
50. How is the price of a bond quoted?
51. What information is included in a bond quote?
a. _____
b. _____
c. _____
d. _____
e. _____
52. What benefit does a mutual fund offer to an investor?
53. Describe an index fund.
54. What is the difference between a no-load and a load fund?
55. What is the difference between an open-end fund and a closed-end fund?
56. Discuss the primary characteristics of ETFs.
57. What information is contained in a mutual fund quote?
58. What is the net asset value, or NAV and how is it calculated?
59. The financial industry used the Dow Jones Industrial Average to __
_____
60. Do the companies included in the Dow ever change?
61. What is a criticism of the Dow Jones Industrial Average?
What do many investors prefer to follow instead of the Dow?
62. What happens in a stock market “crash” and how often has it happened?
63. What do analysts many feel has been the cause of the market turmoil in the last two decades??
64 What are curbs and when are they put into effect?
65. What are circuit breakers and when are they put into effect?
66. What is believed to be the cause of the deep decline of 2000-2002?
67. What has happened in the real estate market which has contributed to the financial crisis and market crash of 2008-2009?
68. What should you do when considering investing in today’s economic environment?
1. Sun-2-Shade is a young company that makes self-darkening windshields for the automotive industry. The financial manager of Sun-2-Shade has convinced management that new capital is needed for future growth. He hasn’t yet decided on whether or not to issue stocks or bonds, but he knows that he wants to avoid the difficulty of looking for and marketing to potential investors himself, and prefers to let "experts" perform those functions. How should he go about pursuing this issue?
Learning Goal 2
2. The three major ways stock is traded the United States are:
NYSE Euronext
NASDAQ
OTC
Match the correct answer to each of the following statements.
a. The largest stock exchange in the world.
b. _____ Provides companies and investors with a means to trade stocks not listed on the national exchanges.
c. Some large companies, like Microsoft are traded on this exchange as well as federal, state and city government bonds.
d. Lists approximately 3,200 companies, including many technology companies.
e. Merged with Archipelago, a securities trading company that specializes in electronic trading and recently purchased the second largest exchange in the U.S. the AMEX.
f. A network of several thousand brokers, who maintain contact with each other and buy and sell securities through a nationwide electronic system.
4. In discussing stocks, there are several terms with which you need to be familiar:
Stock Pre-emptive right
Stock certificate Preferred stock
Dividends Cumulative preferred stock
Common stock Callable preferred stock
Match the correct term to each of the following:
a. Carmen Arauz was considering buying this type of stock, but was somewhat concerned about the risk when she learned that as a stockholder of this type, if the firm closed, she would be the last to share in the firm's assets.
b. When her grandson was born, Judi Burton bought 100 shares of her favorite stock, and gave his parents this, as evidence of his ownership, which showed the number of shares owned, the name of the company, and the type of stock.
c. As Judi’s grandson Burke grew he received these periodic payments from his stock, which his parents invested for college.
d. When Judi was deciding which kind of stock to purchase, she decided upon this type, because the dividends are fixed and must be paid before other dividends are paid. Further, there are no voting rights with this type of stock.
e. What Burke doesn't have is this, which is the right of the stockholder to purchase new shares when the firm makes a new issue, so that his proportionate ownership in the company is maintained.
f. One of the advantages of Burke's stock is that if the company misses his dividend, the company must pay it before it pays any other, and the missed dividends accumulate.
g. Either common or preferred, this represents ownership in a firm.
h. When Judi Burton bought these shares she made sure her stock didn’t have this feature, which would require her grandson Burke to sell his shares back to the corporation.
5. Why do you think Judi Burton decided to buy her grandson Burke preferred stock instead of common stock?
Learning Goal 4
6. In discussing bonds, there are several terms with which you need to be familiar:
Bond Secured bonds
Interest Sinking fund
Principal Callable bond
Maturity date Convertible bond
Unsecured bonds (debentures)
Match the correct term to each of the following descriptions:
a. Gerry Hoffman will receive this on the date her bond becomes due in the year 2020.
b. Beth Galganski will receive the principle value of her bond on this date.
c. Tom Huff is in finance with Sun-2-Shade. Each quarter Sun-2-Shade puts money in this fund to pay off previously issued bonds, and Tom checks the amount of money the company has in the fund to be sure the company can pay off their bond issue on the maturity date.
d. Because it has declared bankruptcy in the past, and the future is uncertain, General Motors would probably not be able to issue this type of bond.
e. Bonnie Andersen receives $100 per year from her bond because this is a 10% bond.
f. Mobil Oil issued an unsecured one at 14.4 percent due in 2020.
g. TNG Enterprises issued this kind of bond, because they forecasted a decline in interest rates in a few years, and wanted the flexibility of being able to pay off the bond early.
h. Bill Paterson bought this type of bond because he anticipated exchanging it for common stock in the firm later.
i. Caldwell Industries used real estate holdings as collateral for their bonds.
Learning Goal 5
7. Five criteria to use when selecting a specific investment strategy are
Investment risk Liquidity
Yield Tax consequences
Duration
Read the following situations and evaluate the criteria in terms of the needs of the potential investors.
a. A young couple wants to invest money to begin a college tuition fund for their 5-year-old child. Since the child has no income, they are going to put the account in his name to avoid taxes.
b. A two-career couple; both anticipate retirement within the next five years.
c. A single person, just graduating from college; just starting a high paying job and wants to build capital. Not concerned about losing money at first.
Learning Goal 6
8. As a potential investor in stocks, there are several terms used in securities trading with which you should be familiar:
Stockbroker Stock splits
Growth stocks Round lots
Income stocks Margin calls
Blue chip stocks Mutual funds
Penny stocks ETFs
Market order Diversification
Limit order Bulls
Bears Prospectus
Capital gains Index fund
Buying on margin
Match the term that would apply to the following descriptions:
a. In 2006 Monsanto gave its stockholders one additional share of stock for every share they owned. This reduced the price from $80 per share to around $40 per share.
b. _____ Evelyn Minervi likes to dabble in the stock market. Last year she bought a number of stocks of this type, which each sold for $1.45 cents per share, but which were considered fairly risky.
c. Joe Contino works in this job for a major brokerage firm, buying and selling stocks and bonds for his clients.
d. Ron Stahl recently purchased this amount, exactly 100 shares, of Navistar stock.
e. Dexter Inholt wanted to buy 500 shares of Ford at $40, each, but he only had $12,000 to invest, so he borrowed the $8,000 he still needed from his brokerage firm.
f. The stock of General Electric, which pays regular dividends and has had fairly consistent growth in its stock price, is considered this type of stock.
g. _____ Marina Vasquez called her broker and asked him to buy Pepsico stock at the best price he could get, under this type of order.
h. Hong Le believed the stock market was going to take a big jump after the most recent national elections, and purchased the stocks she wanted in anticipation of stock price increases.
i. Lee Kornfeld, a prosperous doctor, has a lot of money invested in the market. He recently called his broker and told her to buy the stock of several firms after the price went down to a certain level under this type of order.
j. Dexter Inholt bought Pfizer stock on margin a few weeks ago. When Pfizer’s stock took a slight dip in price, Dexter Inholt got worried that his broker would issue this and would ask him to come up with some money to cover the losses the stock suffered.
k. LaTonya Adams is a first time investor, unfamiliar with the market. She wants to get into the market, but diversify her risk, and invest in lots of firms. Her brother advised her to get into one of these, because then an expert does the research and manages the fund.
l. Because he is investing money for his son's college education, Tim Martin decided to invest in several public utilities, because they offer a high dividend yield for the investment and usually keep up with inflation.
m. The Chesterfield Investment Club always sends for this document, which discloses the financial information of the firms in which the club is interested in investing.
n. Monte McHewie sold many of the stocks he was holding after he heard some economic news that led him to believe prices in the stock market were going to decline soon, indicating this type of market.
o. Lindsey Schopp has a portfolio that consists of 10 percent high-risk growth stocks, 40 percent mutual funds, 30 percent government bonds, and 20 percent commodities. Lindsey has focused on this in creating her portfolio.
p. Casey Argetsinger bought several shares of a relatively new company, for $7.50 per share. The stock paid no dividend, but was in the biotechnology field, and was predicted to grow by 20 percent per year over the next 10 years.
q. When Ben and Casey Miller decided to buy a house, they sold a number of the stocks they had been holding. They found that there was a significant difference between what they paid for the stock, and the price at which they were able to sell it. So much so, that they were able to make a substantial down payment on their new house. This difference in selling prices was called their _____.
r. Chad Mueller is 21 years old, and working at his first job out of college. He knows the value of saving money early, and wants to start investing now in mutual funds. He has decided on this type of fund, one that focuses on certain kinds of stock which covers the whole stock market.
s. Samantha Glenn is a new investor who has decided to try a new way to diversify. Samantha is focusing on this kind of investment, which is a collection of stocks that unlike a mutual fund can be trading throughout the entire trading day, offering Samantha more flexibility than a mutual fund.
Learning Goal 7
9. The managers of Sun-2-Shade are considering whether or not to issue stocks or bonds. Naturally, if the company issues bonds it wants to make sure that the bond is attractive for investors. What are the considerations that the managers need to look at to attract potential investors in their bonds? What will potential investors consider?
Learning Goal 9
10. The financial section of the Wall Street Journal contains stock and bond quotes, the Dow Jones Index and mutual fund quotes. Complete the following exercises, using the Wall Street Journal, or your local newspaper , or online, at a variety of sites, such as www.excite.com , www.yahoo.com www.motleyfool.com or, for mutual funds, at www.morningstar.com .
a. Get the stock quotes for a company of your choice and get the following information.
1. What was the actual price of the stock at the close of the day? ____
2. What was the net change in dollars? ____
3. What was the highest price the stock traded for in the previous year? _
4. How many shares were traded that day? _____
5. What is the company’s earnings per share? _____
6. What is the P/E ratio for this company? _____
Click on Key Statistics for this company.
7. What was the last dividend paid and when was it paid? ___
8. When was the last stock split, and what was the split factor? ___
b. Go to www.yahoo.com and click on finance. Click on mutual funds.
Choose a mutual fund and answer the following questions:
1. What is the net asset value? ____
2. Is this a “no load” fund? ____
3. What is the fund family? ____
4. What is the year to date return? ____
5. What is the Morningstar rating? ____
6. What is the minimum investment? ____
d. Look at the Dow Jones Industrial Average during the time your class is studying this chapter. Answer the following questions:
1. Have stock prices trended up or down over the last 6 months?
2. What was the highest Dow Jones Industrial Average in the last 6 months?
3. What was the lowest?
Learning Goal 1
1. One of the major functions of the securities markets is to:
2. Which of the following statements is incorrect?
a. The only time a corporation receives the money from the sale of stock is after the IPO.
b. The IPO is handled in the secondary market.
c. The first public offering of a corporation’s stock is called an IPO.
d. Investors buy and sell stocks in the secondary market.
3. An investment-banking firm underwrites a new issue of stocks and bonds by:
a. buying the entire bond or stock issue a company wants to sell at an agreed discount.
b. guaranteeing a minimum price in the market for a stock or bond.
c. selling the entire bond issue for the issuing firm in global markets.
d. putting up collateral for long term loans, such as bonds.
Learning Goal 2
4. Which stock is the largest electronic stock trading market, and lists such companies as Google, Starbucks, Cisco and Dell?
a. NASDAQ
b. NYSE
c. AMEX
d. Chicago exchange
5. When the International Ladies Investment Club is deciding on which stock to purchase, the Club will often request a _____before making that decision.
a. insider report
b. income statement
c. prospectus
d. disclosure statement
6. One of the benefits of trading on-line is that:
a. investing on-line is more accurate.
b. when you invest on-line you are more likely to make a good decision.
c. on-line trading services are less expensive than regular stockbroker commissions.
d. insider trading is less likely on-line.
Learning Goal 3
7. One of the disadvantages of issuing stock is that:
d. Stockholder investments must be repaid.
8. Daddy Warbucks bought his daughter Annie some stock for her birthday. The type of stock Daddy bought has a fixed dividend, and if the dividend isn’t paid when it is due, the missed dividend will accumulate and be paid later. Daddy bought Annie
a. common stock.
b. cumulative preferred stock.
c. convertible stock.
d. preemptive right stock.
9. Dividends are paid:
a. based on the prevailing market price of the stock.
b. before a firm pays interest to bondholders.
c. as determined by the stockholders.
d. from a firm’s profits.
Learning Goal 4
10. Which of the following is not accurate when considering the advantages of selling bonds?
a. The debt is eventually eliminated when the bonds are paid off.
b. Interest on the bonds is not a legal obligation.
c. Bondholders have no say in running the firm.
d. interest is tax deductible.
11. Issuing a ____ permits a bond issuer to pay off the bond’s principal prior to its maturity date.
a. sinking fund
b. convertible bond
c. callable bond
d. maturity date
12. On the maturity date of a bond, the issuing company will pay:
a. the bondholder the bond principal in full.
b. the investment banking firm the sinking fund.
c. the bondholder the interest accrued for the duration of the bond.
d. a dividend to the institutional investors.
Learning Goal 5
13. Ramon and Mariel Martinez are in their late 50s and hoping to retire within a few years. Their daughter, Elisa has just begun a new job after graduate school, and is considering investing now for some future needs, maybe a house, or even retirement. What investment advice would you give?
a. Ray and Mariel should consider a high risk/high return investment, since they need to make as much money as possible before they retire.
b. Elisa needs to be conservative, because she is young and may lose her job sometime over her career and need the money.
c. Ray and Mariel should consider more conservative investments, as they want to retire soon.
d. Ray and Mariel, and Elisa should all consider investing in growth stocks, since the prices of those stocks will rise.
14. Linda Hutton is considering investing in the stock market. Linda wants to be sure to be able to get her money back whenever she wants. Linda is concerned with:
a. growth.
b. yield.
c. tax consequences.
d. liquidity.
Learning Goal 6
15. Maria Chadwick is interested in investing in the stock of a corporation that pays regular dividends and generates consistent growth in the price of a share. Maria is interested in purchasing
a. growth stocks.
b. income stocks.
c. blue chip stocks.
d. penny stocks.
16. When the price of a share of U.S. On Line went up to $150 per share, the company declared a 3 for 1 stock split. The price of a share of U.S. On Line stock is now approximately:
a. $100 per share.
b. $75 per share.
c. $50 per share.
d. $25 per share.
17. Irena Dadiavich bought several shares of Google stock a couple of years ago for around $100. When Irena saw that Google was selling for over $400 a share she decided to sell all of her shares and take the profits to buy a new car. The difference between the price at which Irena bought the stock and the price at which she sold it is called:
a. a market order
b. capital gains
c. a bear market
d. premium
18. Adam Culbreath wanted to invest in the stock market, but didn’t have the entire $10,000 he needed to buy the shares of the company he wanted. Adam does have $7,000, so he decided to borrow the remainder in order to be able to buy the stock he wanted. Adam:
a. is investing in junk bonds.
b. is buying on margin.
c. is completely safe as he can always count on the price of his stock to go up.
d. is interested in diversification.
19. Which of the following is not included in a stock quote?
Learning Goal 7
20. The best type of bond for an investor who wants low risk is:
a. a premium bond.
b. a U.S. government bond.
c. a discount bond.
d. a callable bond.
21. A bond that sells for more than face value is called a
a. premium bond.
b. U.S. government bond.
c. discount bond.
d. callable bond.
22. If the corporate bond price is stated as 89 ½, the price an investor would have to pay is:
a. $890.50.
b. $8950.
c. $895.
d. $89.50.
Learning Goal 8
23. The benefit of a mutual fund for investors is that
a. mutual funds help investors to diversify and invest in many different companies.
b. an investor doesn’t have to do as much research.
c. mutual funds are less expensive than most individual shares of stock.
d. mutual funds don’t charge a commission or up-front fee.
24. An index fund is a mutual fund that:
Learning Goal 9
25. The Dow Jones Industrial Average:
a. identifies recessions from the last 30 years.
b. gives an indication of the ups and downs of the stock market over time.
c. compiles average stock prices of all stocks on the NYSE.
d. shows the average stock price of 20 stocks for the last year.
a. requires that only stocks of certain companies can be traded.
b. is when a key computer is turned off and program trading is halted.
c. halts trading for a half hour to two hours when the Dow falls 10, 20, or 30 percent in a day
Learning Goal 1
1. _____ In the securities markets, the secondary markets handle the sale of previously issued securities between investors.
2. _____ An institutional investor is a large investor who buys the entire bond or stock issues a company wants to sell.
Learning Goal 2
3. _____ The Securities and Exchange Commission is responsible for regulating activities in the various exchanges.
4. _____ Insider trading involves the use of knowledge or information that individuals gain through their position that allows them to benefit unfairly from fluctuations in security prices.
5. _____ Investors in the United States are unable to invest in foreign companies, and vice versa
Learning Goal 3
6. _____ Dividends are declared by a company’s board of directors.
7. _____ Common stock normally does not include voting rights.
8. _____ Preferred stock can be convertible to shares of common stock.
Learning Goal 4
9. _____ Bondholders receive one vote for each bond they own in a company.
10. ____ Josh Hayes intends to invest in a bond, but at some point believes it may be beneficial to change that bond over to common stock in the company he is investigating. Josh should consider a convertible bond.
11. ____ A company is legally bound to pay the interest on a bond, but not the principal amount
Learning Goal 5
12. ____ A stockbroker is a registered representative who acts as an intermediary to buy and sell stocks for clients
13. ____ A young person saving for retirement can afford to invest in higher risk stocks than a person who is nearing retirement age.
14. ____ One of the major criteria to consider when investing is duration, which is the amount of time your money is committed to that investment.
Learning Goal 6
15. ____ “Bulls” are investors who believe that stock prices are going to rise, so they buy in anticipation of the increase.
16. ____ Companies may offer a stock split when the price of their stock is too high and the company wants to stock to be more desirable in the market.
17. ____ A market order tells a broker to buy or sell a particular stock at a specific price.
18. ____ One of the items found in a stock quote will be the highest price paid in the last 52 weeks
Learning Goal 7
19. ____ In general, the higher the risk of a bond, the lower the interest rate the issuer must offer in order to keep the price low so it will be attractive to investors.
20. ____ One of the disadvantages of a bond as an investment is that once purchased, it must be held to maturity.
Learning Goal 8
21. ____ Mutual funds are probably the best way for smaller investors to get started.
Learning Goal 9
24. ____ Many investors believe the Dow is not an accurate measure of stock prices, and prefer to follow a stock index such as Standard and Poors 500.
If you had purchased $1000 of a blue chip stock, such as Coca-Cola, General Electric or IBM exactly one year ago, what would your capital gain, or loss, be as of today? What would the difference be from 5 years ago?
Calculate the same information for a technology related company, such as Cisco, Microsoft or Yahoo.com Would you have a capital gain? How much?
Now, visit an online broker such as www.etrade.com or www.ameritrade.com How do their fees compare to trading online with a discount broker such as Charles Schwab – www.charlesschwab.com, or a traditional broker such as A.G. Edwards www.agedwards.com
1. Institutional investors |
11. Investment bankers |
20. Bond |
2. Over the counter market (OTC) |
12. Interest |
21. Dow Jones Industrial Average |
3. Stock certificate |
13. Debenture bond |
22. Securities and Exchange |
4. Program trading |
14. Buying stock on margin |
23. Prospectus |
5. Common stock |
15. Dividends |
24. NASDAQ |
6. Sinking fund |
16. Stock split |
25. Capital gains |
7. Stockbroker |
17. Diversification |
26. Initial Public Offering (IPO) |
8. Stock exchange |
18. Stocks |
27. Junk bonds |
9. Maturity date |
19. Mutual fund |
28. Exchange-traded funds (ETFs) |
10. Preferred stock |
|
|
Learning Goal 1
The Function of Securities Markets
1. Two major functions of securities markets are:
a. to assist businesses in finding long-term funding they need to finance operations, expand their businesses, or buy goods and services.
b. to give investors a place to buy and sell investments such as stocks and bonds
to help build their financial future.
2. The primary market handles the sale of new securities. This is the only time corporations make money on the sale of securities. After the corporation has made its money, the secondary market handles the trading of securities between investors. The proceeds of sales in the secondary market go to the investor selling the stock, not to the corporation whose stock is sold.
3. Investment bankers
a. help companies prepare the extensive financial analyses necessary to gain SEC approval for stock or bond issues.
b. underwrite new issues, which means that the investment banker will buy the entire bond or stock issue a company wants to sell at an agreed upon discount and then sell the issue to private or institutional investors at full price.
4. Institutional investors are mutual funds, pension funds, insurance companies and banks. Because they have such large buying power, they are a powerful force in the securities markets.
5. The NYSE Euronext is the world’s largest securities exchange. It is a group of stock exchanges in six countries, with 8,000 stocks listed including 78 of the 100 largest companies in the world.
6. The OTC market is a network of several thousand brokers who maintain contact with one another and buy and sell securities through a nationwide electronic system. Trading is conducted between two parties directly, instead of through an exchange like the NYSE Euronext.
7. The NASDAQ is a telecommunications network that links dealers across the nation so they can buy and sell securities electronically. It is the largest U.S. electronic stock trading market.
8. The Securities Act of 1933 protects investors by requiring full disclosure of financial information by firms selling new stocks or bonds. Congress passed this act to deal with the “free-for-all” atmosphere that existed during the Roaring Twenties.
9. The Securities and Exchange Act of 1934:
a. created the Securities and Exchange Commission.
b. requires that companies trading on the national exchange must register with the SEC and provide annual updates.
c. established guidelines companies must follow issuing stocks or bonds to the public
d. established guidelines to prevent insiders from taking advantage of privileged information.
10. Insider trading is the use of knowledge or information that individuals gain through their position that allows them to benefit unfairly from fluctuations in security prices.
The term “insider” includes just about anyone with securities information that is not available to the general public.
12. A stock’s par value is a dollar amount assigned to each share of stock by the corporation’s charter. Some states use par value as a basis for calculating the state’s incorporation charges and fees. Today most companies issue “no-par” stock.
13. Important elements of dividends are:
a. Dividends are a part of a firm’s profits that may be distributed to shareholders.
b. Dividends are declared by a corporation’s board of directors and are generally paid quarterly.
c. Dividends will be distributed as either cash payments or additional shares of stock.
14. The advantages of raising funds through the sale of stock are:
a. Because stockholders are owners, they never have to be repaid.
b. There is no legal obligation to pay dividends.
c. Selling stock can improve the condition of the balance sheet because it creates no debt.
15. The disadvantages of issuing stock are:
a. As owners, stockholders can alter the control of the firm, through voting for the board of
directors.
b. Dividends are paid out of after tax profits so are not tax deductible.
c. Management decision-making can be hampered by the need to keep the stockholders happy.
16. Three rights of common stockholders are:
a. the right to vote for the board of directors and important issues affecting the company.
b. to share in the firm’s profits though dividends declared by the board of directors.
17. Owners of preferred stock:
a. have a preference in the payment of dividends.
b. have a prior claim on company assets if the firm goes out of business.
18. Normally preferred stockholders do not get have voting rights in the firm.
Preferred stock is generally issued with a par value that becomes the base for a fixed dividend the firm is willing to pay.
19. The special features of preferred stock are that it can be:
a. Callable, like bonds. This means a company could require preferred stockholders to sell back their shares.
b. Convertible to common stock.
c. Cumulative. If one or more dividends are not paid when due, the missed dividends of cumulative preferred stock will accumulate and be paid later.
20. A company that issues bonds has a legal obligation to pay regular interest payments to investors and repay the entire bond principal amount at a prescribed time, called the maturity date.
21. The principal is the face value of a bond, which the issuing company is legally bound to repay in full to the bondholder.
22. A 10% bond with a maturity date of 2030 means that the bondholder will receive $100 in interest per year until the year 2030, when the full principal, most likely $1000, must be repaid. Interest is usually paid in two installments each year.
23. The interest rate paid on bonds is also called the bond’s coupon rate.
24. The interest rate paid on a bond varies according to factors such as the state of the economy, the reputation of the company issuing the bond, and the going interest rate being paid by U.S. government bonds or bonds of similar companies. Once an interest rate is set it generally can’t be changed.
25. a. Bondholders are not owners of a firm so they have no vote on corporate matters. Management maintains control over the firm’s operations.
b. The interest paid on bonds is tax deductible for the firm.
c. Bonds are a temporary source of funding. They are eventually repaid, and the debt is eliminated.
d. Bonds can be repaid before the maturity date if they contain a call provision, and can also be convertible to common stock.
26. a. Bonds are an increase in debt and could adversely affect the firm.
b. Interest on bonds is a legal obligation. If interest isn’t paid, bondholders can take legal action.
c. The face value of bonds must be repaid at maturity, which could cause cash flow problems.
27. Unsecured bonds, called debentures, are not supported by any collateral. Generally only firms with excellent credit ratings can issue debentures. The other class of bonds, secured bonds, is backed by some tangible asset, or collateral, that is pledged to the bondholder if bond interest isn’t paid.
28. Sinking funds are attractive to firms and investors because:
a. They provide for an orderly retirement of a bond issue.
b. They reduce the risk of not being repaid, and so make the bond more attractive as an investment.
c. They can support the market price of a bond because of reduced risk.
29. A callable bond permits the bond issuer to pay off the bond’s principal before its maturity date. Callable bonds give companies some discretion in long-term forecasting. The company can benefit if they call in a bond issue that pays a high rate of interest, and re-issue new bonds at a lower rate of interest.
30. A convertible bond is a bond that can be converted into shares of common stock in the issuing company. If the value of the firm’s common stock grew in value over time, bondholders can compare the value of the bond’s interest with the possibility of a sizable profit by converting to a specified number of common shares.
Learning Goal 5
How Investors Buy Securities
31. To invest in stocks or bonds, you first decide what stock or bond you want to buy. Then you find a stockbroker. The stockbroker will place an order where the bond or stock is traded and negotiate a price. When the transaction is completed, the trade is reported to your broker who notifies you to confirm your purchase. The same procedures are followed if you sell stocks or bonds. Large brokerage firms maintain automated order systems that allow brokers to enter you order the instant you make, so the order can be confirmed in seconds.
32. On-line trading services are less expensive than regular stockbroker commissions.
33. Customers interested in online trading services are primarily those who are willing to do their own research and make their own investment decisions without the assistance of a broker. The leading online brokerage services provide market information but no advice.
34. The first step in any investment program is to analyze your risk tolerance.
Other factors to consider are your desired income, cash requirements, growth prospects, and hedging against inflation.
35. The five criteria to use when selecting an investment option are:
a. Investment risk – the chance that your investment could go down in value in the future.
b. Yield - the rate of return.
c. Duration – the length of time for which you are committing your assets.
d. Liquidity – how quickly you can get back your money if you need to.
e. Tax consequences – how the investment affects your tax situation.
37. Bulls are investors who believe that stock prices are going to rise, so they buy stock in anticipation of the increase. When overall stock prices are rising, it is called a bull market.
Bears are investors who believe that stock prices are going to decline. These investors sell their stocks before they expect prices to fall. When the prices of stocks decline steadily, it is referred to as a bear market.
38. According to the text, the market price of a common stock is dependent upon the overall performance of the corporation in meeting its business objectives.
39. a. Growth stocks are stocks of corporations whose earnings are expected to grow at a rate
faster than other stocks. They are often considered risky, but they offer investors the potential for higher returns.
b. Income stocks offer investors a high dividend yield on their investment.
c. Blue chip stocks are the stock of high quality companies. They pay regular dividends and generate consistent growth in the company stock price.
d. Penny stocks sell for less than $2. These stocks are considered high risk investments.
40. A market order tells a broker to buy or to sell a sotck immediately at the best price available.
A limit order tells the broker to buy or sell a stock at a specific price, if that price becomes available.
41. Companies and brokers prefer to have stock purchases conducted in round lots, which are purchases of 100 shares at a time. Investors often buy stock in odd lots which are purchases of less than 100 shares at a time.
42. When investors cannot afford to buy shares of stock in companies selling for a high price, the company may choose to declare a stock split; that is, they issue two or more shares for every share of stock currently outstanding.
A two-for-one stock split the effect of dropping the price of a share, by half, which giving the investor twice the number of shares. For example, if a stock was selling for $150 and you had one share, after a two for one stock split, you would have two shares, and each share would be valued at about $75.
This stock split may increase demand for the stock, which may cause the price to go up in the near future.
43. The margin is the portion of the stock’s purchase price an investor must pay with their own money. If a margin rate is 50 percent, an investor may borrow 50 percent of the stock’s purchase price from a broker.
44. The downside of buying on margin is that investors must repay the credit extended by the broker, plus interest.
If an investor’s account goes down in market value, the broker will issue a margin call, requiring the investor to come up with more money to cover the losses the stock has suffered. If the investor is unable to make the margin call, the broker can legally sell shares of the investor’s stock to reduce the broker’s chance of loss.
45. A stock quote will contain the following information:
a. The highest and lowest price the stock traded for that day
b. The highest and lowest price over the past 52 weeks
c. Stock’s dividend yield
d. The price/earnings (P/E) ratio
e. Return on equity
Learning Goal 7
Investing in Bonds
46. For those who desire limited risk and guaranteed income, U.S. Government bonds are a secure investment backed by the full faith and credit of the federal government. Municipal bonds are also secure, and are offered by local governments, and often have advantages such as tax free interest.
47. Two questions first time corporate bond investors have are
a. "If I purchase a bond, do I have to hold it to the maturity date?" The answer is no. However if you decide to sell your bond before its maturity date, you are not guaranteed to get the face value of the bond.
b. " How can I assess the investment risk of a particular bond issue?" Standard and Poor’s and Moody’s Investor Service rate the level of risk of many corporate and government bonds.
48. If your bond does not have features that make it attractive to other investors, you may have to sell your bond at a discount which is a price less than face value
If the bond is highly valued, you may be able to sell it at a premium which is a price above face value.
49. Standard & Poor’s Investment Advisory Service and Moody’s Investor Service define junk bonds as those with high-risk and high default rates. If the company can’t pay off the bond, the investor is left with a bond that isn’t worth more than the paper it’s written on.
50. A bond price is quoted as a percentage of $1000.
51. A bond quote in the paper contains
a. the interest rate
b. the maturity date
c. rating
d. price of the bond
e. whether the bond is callable
Learning Goal 8
Investing in Mutual Funds and Exchange-Traded Funds
52. The benefit of a mutual fund to an investor is they can buy shares of the mutual fund and share in the ownership of many different companies they could not afford to invest in individually. Thus mutual funds help investors diversify.
53. An index fund is a fund that invests in a certain kind of stocks or bonds, or in the market as a whole. An index fund may focus on large companies, small companies, emerging countries, or real estate.
54. A no-load fund is one that charges no commission to either buy or sell its shares. A load fund would charge a commission to investors.
55. An open-end fund will accept the investment of any interested investors. Closed-end funds offer a specific number of shares for investment. Once the fund reaches its target number, no new investors are admitted into the fund.
56. ETFs resemble both stock and mutual funds in that they are collections of stocks and bonds that are traded on exchanges, but themselves are traded more like individual stocks than like mutual funds. Unlike mutual funds, ETFs can be traded throughout the entire trading day, like individual stocks.
57. The information contained in a mutual fund quote includes:
58. The Net Asset Value, NAV, is the market value of the mutual fund’s portfolio divided by the number of shares it has outstanding. The NAV is the price per share of the mutual fund.
59. The financial industry uses the Dow Jones Industrial Average to give an indication of the direction of the stock market over time.
60. The companies in the Dow have changed over the years. The Dow started with 12 stocks, and now contains stocks of 30 different companies. The companies included in the Dow have changed over the years when it’s deemed appropriate to reflect changes in our economy.
61. Critics of the Dow Jones Average argue that if the purpose of the Dow is to give an indication of the direction of the broader market over time, the 30-company sample is too small to get a good statistical representation.
Many investors and market analysts prefer to follow stock indexes like the Standard and Poor’s 500 that tracks the performance of many more companies. Investors also closely follow the NASDAQ.
62. A stock market crash occurs when the stock market loses a significant part of its value in a single day. The largest crashes occurred in 1929, 1987, and 1997, 2000-2002 and 2008
63. Many analysts believe that program trading was a big cause of the stock market drop in the last two decades. In program trading, investors give computers instructions to automatically sell if the price of their stock dips to a certain price to avoid potential losses.
64. Program trading curbs are put into effect when the Dow moves up or down by a large number of points in one trading day. A key computer is turned off and program trading is halted.
65. Circuit breakers are more drastic restrictions than curbs, and are triggered when the Dow falls 10, 20, or 30 percent in one day. Depending upon the rate of decline and the time of day the circuit breakers will halt trading between a half hour and two hours to give traders a chance to assess the situation. If the Dow drops 30 percent trading closes for the entire day.
66. The deep decline of 2000-2002 is believed to be the bursting of the “dot.com” bubble. A bubble occurs when too many investors drive the price of something unrealistically high.
67. Like the earlier tech bubble, the real estate bubble burst in 2008. Investors believed home prices would increase consistently. Financial institutions reduced lending requirements to make more mortgage loans, homebuilders overbuild, and buyers overspent. The government contributed to the problem by requiring mortgages to be given to low and moderate income buyers with weak credit scores, and without verification of income. These were called subprime loan.
These loans were packaged as securities that were sold to investors. When the real estate market peaked and prices began to fall, many financial institutions were driven into a panic, and some failed.
68. When considering investing today, it is important to diversify your investments and understand the risks of investing. It is also wise to take a long-term perspective. It’s important to do research, keep up with the news, and make use of investment resources such as newspapers, magazines, newsletters, the Internet, and TV programs.
CRITICAL THINKING EXERCISES
1. The finance manager of Sun-2-Shade has the opportunity to avoid the difficulties of a new issue by making use of specialists in the securities markets such as investment bankers. These companies will underwrite the new issue, by purchasing the entire issue for a discount. The investment banker will then sell the issue on the open market to either private or institutional investors, such as pension funds, mutual funds, insurance companies, or banks.
Learning Goal 2
2. a. NYSE Euronext
e. NYSE Euronext
f. OTC
Learning Goals 3,4
3. As we learned in previous chapters, one of the jobs of a finance manager is to determine the best way for a firm to raise long-term capital. When deciding which form of long-term funding is best a finance manager will weigh the options of both equity and debt funding.
You will probably tell Eric that bonds offer several long term financing advantages. Perhaps one of the most important to Eric will be that bondholders are not owners of the firm, so they won’t have a vote on corporate matters. So, Eric and his management team will maintain control over the firm. Other benefits include the fact that bond interest is tax deductible, and that eventually the debt will be repaid. If interest rates are high when the bonds are issued, they can be called and re-issued when rates have lowered.
Conversely, when the firm goes into debt by issuing bonds, there could be an adverse affect on the market’s perception of the firm. If for some reason a cash flow problem develops, interest is a legal obligation, and the firm would still have to pay interest, even with a negative cash flow, and provisions have to be made for when the face value has to be paid off. This could also negatively affect cash flow.
Stocks offer the opportunity for a firm to stay out of debt, and there is no legal obligation to pay dividends. Selling stock can also improve the look of the balance sheet.
The downside of stock issues is that the structure of ownership changes, and stockholders have the right to vote on the board of directors, and sometimes decisions have to be made with the primary goal of keeping stockholders happy. Eric may not want to give up his ownership control. Another downside is that dividends, if paid, are not tax deductible.
Learning Goal 3
4. a. Common stock e. Pre-emptive right
b. Stock certificate f. Cumulative preferred
c. Dividends g. Stock
d. Preferred stock h. Callable preferred
5. While both forms of stock represent ownership, there are several differences between preferred and common stock. First, an owner of common stock has the right to vote, and so can influence corporate policy. Judi probably did not consider this to be important, as Burke was a baby, and wouldn't really be concerned about such things! Further, common stock is considered to be more risky than preferred, because if a company closes, common stockholders share in assets only after bondholders and preferred stockholders. Also, while preferred dividends are fixed, and sometimes accumulate, common stock dividends will only be paid after both bondholders and preferred stockholders receive their interest and dividends. If Judi was interested in starting a "college fund" for Burke, then the preferred stock was a better match for her needs.
Learning Goal 4
6. a. Principal f. Bond
b. Maturity date g. Callable bond
c. Sinking fund h. Convertible bond
d. Unsecured bond (debenture) i. Secured bond
e. Interest
Learning Goal 5
7. a. This couple would probably want a low to moderate risk investment, which will increase
their principal over time. Tax consequences will be minimal, at least at first, as the child will have little income in the early years.
(If they opt for an interest or dividend bearing type of account, the child will be earning income, and tax consequences may become a more important consideration). They will choose an investment that will yield a high return over the long run, and liquidity isn't important for now.
b. Since this investment may be for retirement, this couple will probably want a low risk
investment, with as high an after-tax yield as they can earn. It will be of short duration, since they plan to retire in five years, and they may want to keep it fairly liquid in case they retire in less than five years. A big factor will be the tax consequences, as they are a two-income family, and are probably in a high tax bracket with few deductions.
c. A young, single person will choose a higher risk investment than the others, because they probably are not concerned with long-term considerations such as retirement. Since they want to build capital, the yield will be important for the short term. This individual may want to keep investments of short duration to make a large return in a few years, when they may want the money as a down payment for a house, for example, and they may want them fairly liquid. Tax consequences will be important, as there are few deductions, and they may be in a relatively high bracket
Learning Goal 6
8. a. Stock split k. Mutual fund
b. Penny stocks l. Income stock
c. Stockbroker m. Prospectus
d. Round lot n. Bear
e. Buying on margin o. Diversification
f. Blue chip p. Growth stock
g. Market order q. Capital gains
h. Bull r. Index fund
i. Limit order s. ETFs
j. Margin call
Learning Goal 7
9. Managers at Sun-2-Shade will have to determine the market’s perceived rate of risk for this bond. If the bond is considered risky, as determined by Standard & Poors and Moody’s Investors Service, then the interest rate will have to be higher than if it were considered to be a safer investment. Investors will invest in a bond that is considered risky only if the potential return to them is high enough.
Sun-2-Shade will be offering corporate bonds and the face value will most likely be $1,000. Investors will consider how soon the bond matures, the interest rate, and whether or not it has other features that will allow the investor to sell either at a premium or a discount.
Learning Goal 9
10. Your answers for each section will vary according to which companies you choose to study, and when you are studying this chapter. As for the Dow Jones Industrial Averages, stock prices trended upward in the mid-1990s and the average broke 9000 for the first time in early 1998. Stock prices quickly recovered from the drop in October 1997. By late 1999, the Dow Jones Industrial Average hit over 11,000. During the early 2000s the Average varied, and in early 2001, the Dow Jones fell rapidly, plunging to below 10,000. It started a very slow recovery in mid- 2003. In 2008-2010 the market had a steep decline.
1. c 1. T 14. T
2. b 14. d 2. F 15. T
3. a 15. c 3. T 16. T
4. a 16. c 4. T 17. F
5. c 17. b 5. F 18. T
6. c 18. b 6. T 19. F
7. b 19. a 7. F 20. F
8. b 20. b 8. T 21. T
9. d 21. d 9. F 22. T
10. b 22. c 10. T 23. F
11. c 23. a 11. F 24. T
12. a 24. d 12. T 25. T
13. c 25. b 13. T
26. c
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