Practical Investment Management 4th Edition Solution Manual
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1
Chapter 1
The Concept of Investing
OUTLINE
Introduction
Investing Defined
Investment Alternatives
Assets
Securities
Security Groupings
Three Reasons for Investing
Income
Appreciation
Excitement
The Academic Study of Investments
Theoretical Research
Empirical Research
Professors vs. Practitioners
SUMMARY
Even in this short introductory chapter some of the terminology was probably unfamiliar: stock
splits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific to
the investment field, and these terms need to become second nature to anyone involved in investing
and investment management. Each chapter begins with a list of the Key Terms covered within that
chapter. A good study technique is to focus on them.
The theoretical discussions presented in this book deal generally with fundamental relationships
we know absolutely. This background—coupled with coverage of market mechanics, folklore, and
institutional detail—should help to develop an ability to speak intelligently about the investment
business and to influence future financial decisions.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Saving is a short or long term activity associated with little chance of loss of principal.
Investing is a long-term activity in a risky venture. The risk can be modest or substantial
depending on the characteristics of the investment.
2. The SIPC provides investors who have accounts at a brokerage firm with protection against
failure of the brokerage firm, loss by theft or fire, or fraud of a firm employee. It does not
provide protection against a loss in market value from making poor investments
3. A financial asset on one person’s personal balance sheet also appears on someone else’s
balance sheet as a liability. Stocks and bonds are financial assets that appear on the right
hand side of the corporate balance sheet. A real asset (such as land or gold) does not have a
corresponding liability.
Chapter 1
The Concept of Investing
OUTLINE
Introduction
Investing Defined
Investment Alternatives
Assets
Securities
Security Groupings
Three Reasons for Investing
Income
Appreciation
Excitement
The Academic Study of Investments
Theoretical Research
Empirical Research
Professors vs. Practitioners
SUMMARY
Even in this short introductory chapter some of the terminology was probably unfamiliar: stock
splits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific to
the investment field, and these terms need to become second nature to anyone involved in investing
and investment management. Each chapter begins with a list of the Key Terms covered within that
chapter. A good study technique is to focus on them.
The theoretical discussions presented in this book deal generally with fundamental relationships
we know absolutely. This background—coupled with coverage of market mechanics, folklore, and
institutional detail—should help to develop an ability to speak intelligently about the investment
business and to influence future financial decisions.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Saving is a short or long term activity associated with little chance of loss of principal.
Investing is a long-term activity in a risky venture. The risk can be modest or substantial
depending on the characteristics of the investment.
2. The SIPC provides investors who have accounts at a brokerage firm with protection against
failure of the brokerage firm, loss by theft or fire, or fraud of a firm employee. It does not
provide protection against a loss in market value from making poor investments
3. A financial asset on one person’s personal balance sheet also appears on someone else’s
balance sheet as a liability. Stocks and bonds are financial assets that appear on the right
hand side of the corporate balance sheet. A real asset (such as land or gold) does not have a
corresponding liability.
1
Chapter 1
The Concept of Investing
OUTLINE
Introduction
Investing Defined
Investment Alternatives
Assets
Securities
Security Groupings
Three Reasons for Investing
Income
Appreciation
Excitement
The Academic Study of Investments
Theoretical Research
Empirical Research
Professors vs. Practitioners
SUMMARY
Even in this short introductory chapter some of the terminology was probably unfamiliar: stock
splits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific to
the investment field, and these terms need to become second nature to anyone involved in investing
and investment management. Each chapter begins with a list of the Key Terms covered within that
chapter. A good study technique is to focus on them.
The theoretical discussions presented in this book deal generally with fundamental relationships
we know absolutely. This background—coupled with coverage of market mechanics, folklore, and
institutional detail—should help to develop an ability to speak intelligently about the investment
business and to influence future financial decisions.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Saving is a short or long term activity associated with little chance of loss of principal.
Investing is a long-term activity in a risky venture. The risk can be modest or substantial
depending on the characteristics of the investment.
2. The SIPC provides investors who have accounts at a brokerage firm with protection against
failure of the brokerage firm, loss by theft or fire, or fraud of a firm employee. It does not
provide protection against a loss in market value from making poor investments
3. A financial asset on one person’s personal balance sheet also appears on someone else’s
balance sheet as a liability. Stocks and bonds are financial assets that appear on the right
hand side of the corporate balance sheet. A real asset (such as land or gold) does not have a
corresponding liability.
Chapter 1
The Concept of Investing
OUTLINE
Introduction
Investing Defined
Investment Alternatives
Assets
Securities
Security Groupings
Three Reasons for Investing
Income
Appreciation
Excitement
The Academic Study of Investments
Theoretical Research
Empirical Research
Professors vs. Practitioners
SUMMARY
Even in this short introductory chapter some of the terminology was probably unfamiliar: stock
splits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific to
the investment field, and these terms need to become second nature to anyone involved in investing
and investment management. Each chapter begins with a list of the Key Terms covered within that
chapter. A good study technique is to focus on them.
The theoretical discussions presented in this book deal generally with fundamental relationships
we know absolutely. This background—coupled with coverage of market mechanics, folklore, and
institutional detail—should help to develop an ability to speak intelligently about the investment
business and to influence future financial decisions.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Saving is a short or long term activity associated with little chance of loss of principal.
Investing is a long-term activity in a risky venture. The risk can be modest or substantial
depending on the characteristics of the investment.
2. The SIPC provides investors who have accounts at a brokerage firm with protection against
failure of the brokerage firm, loss by theft or fire, or fraud of a firm employee. It does not
provide protection against a loss in market value from making poor investments
3. A financial asset on one person’s personal balance sheet also appears on someone else’s
balance sheet as a liability. Stocks and bonds are financial assets that appear on the right
hand side of the corporate balance sheet. A real asset (such as land or gold) does not have a
corresponding liability.
Chapter 1. The Concept of Investing2
4. The three categories are equity securities, fixed income securities, and derivative assets.
(Note: Futures contracts, a type of derivative, are technically not securities, and are not
under the jurisdiction of the Securities and Exchange Commission. There is little practical
importance to this distinction.)
5. Three motivations for investing are to generate income, to realize capital appreciation, and
for the fun-of-the-chase, or excitement.
6. Suppose a foreign currency dealer sells 100 units of currency A for 1 unit of currency B, sells
50 units of currency C for 1 unit of currency B, and sells 1.8 units of currency A for 1 unit of
currency C. Assume the spread is zero: buying and selling prices are the same. In
equilibrium, two units of currency A should equal one unit of currency C. Because the
dealer sells 1.8 A (instead of 2.0) for each 1.0 C, currency A is overpriced relative to
currency C. This presents an arbitrage opportunity. You want to exchange currency A for C.
Suppose you begin with 100 B and you exchange them for 10,000 A. Next you exchange the
10,000 A for 5,555.55 C. Now convert the 5,555.55 C into 111.11 B. This is an 11.11%
gain with no risk.
7. Theoretical research begins with assumptions about investor behavior, generally assuming
they behave rationally. Mathematical logic then leads to relationships among security prices
that should hold in a rational world. Empirical researchers look at actual market prices and
seek to find statistically significant relationships in the data. Theoretical models are often
tested empirically using market data.
8. An anomaly is an empirical result that is inexplicable by financial theory.
9. Because there is no risk of loss with a U.S. Treasury Bill, many people would consider such
an activity saving rather than investing.
4. The three categories are equity securities, fixed income securities, and derivative assets.
(Note: Futures contracts, a type of derivative, are technically not securities, and are not
under the jurisdiction of the Securities and Exchange Commission. There is little practical
importance to this distinction.)
5. Three motivations for investing are to generate income, to realize capital appreciation, and
for the fun-of-the-chase, or excitement.
6. Suppose a foreign currency dealer sells 100 units of currency A for 1 unit of currency B, sells
50 units of currency C for 1 unit of currency B, and sells 1.8 units of currency A for 1 unit of
currency C. Assume the spread is zero: buying and selling prices are the same. In
equilibrium, two units of currency A should equal one unit of currency C. Because the
dealer sells 1.8 A (instead of 2.0) for each 1.0 C, currency A is overpriced relative to
currency C. This presents an arbitrage opportunity. You want to exchange currency A for C.
Suppose you begin with 100 B and you exchange them for 10,000 A. Next you exchange the
10,000 A for 5,555.55 C. Now convert the 5,555.55 C into 111.11 B. This is an 11.11%
gain with no risk.
7. Theoretical research begins with assumptions about investor behavior, generally assuming
they behave rationally. Mathematical logic then leads to relationships among security prices
that should hold in a rational world. Empirical researchers look at actual market prices and
seek to find statistically significant relationships in the data. Theoretical models are often
tested empirically using market data.
8. An anomaly is an empirical result that is inexplicable by financial theory.
9. Because there is no risk of loss with a U.S. Treasury Bill, many people would consider such
an activity saving rather than investing.
3
Chapter 2
Understanding Risk and Return
OUTLINE
Introduction
Return
Holding Period Return
Yield and Appreciation
The Time Value of Money
Financial calculators
Compounding
Compound Annual Return
Risk
Risk vs. Uncertainty
Dispersion and the Chance of Loss
The Problem with Losses
Risk Aversion
Partitioning Risk
More on the Relationship between Risk and Return
The Direct Relationship
Risk, Return, and Dominance
SUMMARY
The two key concepts in finance are the time value of money and the fact that a safe dollar is worth
more than a risky dollar. The tradeoff between risk and return is the central theme in the investment
decision-making process. Most investors are risk averse, meaning they only take a risk if they believe
they will be rewarded for doing so.
A holding period return is independent of the passage of time and should be used only to compare
investments over identical time periods. The holding period return considers both the yield of an
investment from interest or dividends and appreciation from a change in the investment value.
Time value of money calculations overcome the shortcomings of the holding period return. They
permit a direct comparison between a particular sum today and amounts in the future. The interest rate
that satisfies a time value of money equation is a compound annual return. The number of
compounding periods per year can significantly influence the compound annual return.
A risky situation must involve a chance of loss. Risk is inseparable from time. The greater the time
period, the greater the possible dispersion of results. Investment losses are especially consequential
because an investment that loses x% must rise by more than x% just to break even.
Virtually all investors are risk averse with significant sums of money. In other words, they will not
take a risk with their money unless they believe the risk is warranted by the potential future returns
from the investment.
Total risk encompasses the complete variability of investment results. Total risk can be partitioned
into diversifiable and undiversifiable components. The marketplace only rewards undiversifiable risk.
Risk is unavoidable if an investor seeks more than a trivial return. A direct relationship exists
between expected return and unavoidable risk. Risky investments do not guarantee a return, nor does
unnecessary risk warrant any additional return.
Chapter 2
Understanding Risk and Return
OUTLINE
Introduction
Return
Holding Period Return
Yield and Appreciation
The Time Value of Money
Financial calculators
Compounding
Compound Annual Return
Risk
Risk vs. Uncertainty
Dispersion and the Chance of Loss
The Problem with Losses
Risk Aversion
Partitioning Risk
More on the Relationship between Risk and Return
The Direct Relationship
Risk, Return, and Dominance
SUMMARY
The two key concepts in finance are the time value of money and the fact that a safe dollar is worth
more than a risky dollar. The tradeoff between risk and return is the central theme in the investment
decision-making process. Most investors are risk averse, meaning they only take a risk if they believe
they will be rewarded for doing so.
A holding period return is independent of the passage of time and should be used only to compare
investments over identical time periods. The holding period return considers both the yield of an
investment from interest or dividends and appreciation from a change in the investment value.
Time value of money calculations overcome the shortcomings of the holding period return. They
permit a direct comparison between a particular sum today and amounts in the future. The interest rate
that satisfies a time value of money equation is a compound annual return. The number of
compounding periods per year can significantly influence the compound annual return.
A risky situation must involve a chance of loss. Risk is inseparable from time. The greater the time
period, the greater the possible dispersion of results. Investment losses are especially consequential
because an investment that loses x% must rise by more than x% just to break even.
Virtually all investors are risk averse with significant sums of money. In other words, they will not
take a risk with their money unless they believe the risk is warranted by the potential future returns
from the investment.
Total risk encompasses the complete variability of investment results. Total risk can be partitioned
into diversifiable and undiversifiable components. The marketplace only rewards undiversifiable risk.
Risk is unavoidable if an investor seeks more than a trivial return. A direct relationship exists
between expected return and unavoidable risk. Risky investments do not guarantee a return, nor does
unnecessary risk warrant any additional return.
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Chapter 2: Understanding Risk and Return4
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. This statement is generally true, although the concept of risk normally assumes there are certain
adverse outcomes involving a chance of loss.
2. You cannot comment on the relative performance of competing investments without knowing
their relative risk. It is also possible that investment B was a $1 million venture, while investment
A was a $250 activity. Dollars are what matter, not percentages. If you have the choice between
earning 100% on a $250 investment and 20% on a $1 million investment, everyone will prefer the
latter.
3. A single large loss requires substantial subsequent gains to overcome the loss. The same is true of
a series of small losses. A key point is that a loss of x% requires a gain of more than x% to break
even.
4. Individual preference. People do not like risk, and since choice 2 appears more risky, the possible
payoff on choice 2 for 51-100 coming up must be greater than 0 so that the average payoff is
greater than $100. It depends on the individual, however, to make that choice since people also
differ in terms of how risk averse they are.
5. Increasing the investment horizon increases the potential variability of returns, and hence the
range of possible outcomes from the investment. Given that a wider range of values means more
uncertainty about the outcome, from one perspective more time implies more risk.
6. See text discussion under "Partitioning Risk."
Business Risk Variability of sales
Financial Risk Variability of net earnings from financial leverage
Purchasing Power Risk Variability of real return from inflation
Interest Rate Risk Variability of return, given changes in market interest rates
Foreign Exchange Risk Variability of return caused by varying exchange rates in
investment period
Political Risk Variability of return related to change in governmental
decisions
Social Risk Variability of return related to changing consumer and
business reaction to social issues
7. Tobacco investments, environmental protection, sweatshop businesses, child labor laws outside
the U.S.
8. Individual preference.
9. Individual preference.
10. There is a greater difference with annual versus monthly compounding. As the rate of
compounding increases the incremental increase in dollars earned decreases. There is a smaller
difference between daily and continuous compounding compared to going from annual to monthly
compounding.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. This statement is generally true, although the concept of risk normally assumes there are certain
adverse outcomes involving a chance of loss.
2. You cannot comment on the relative performance of competing investments without knowing
their relative risk. It is also possible that investment B was a $1 million venture, while investment
A was a $250 activity. Dollars are what matter, not percentages. If you have the choice between
earning 100% on a $250 investment and 20% on a $1 million investment, everyone will prefer the
latter.
3. A single large loss requires substantial subsequent gains to overcome the loss. The same is true of
a series of small losses. A key point is that a loss of x% requires a gain of more than x% to break
even.
4. Individual preference. People do not like risk, and since choice 2 appears more risky, the possible
payoff on choice 2 for 51-100 coming up must be greater than 0 so that the average payoff is
greater than $100. It depends on the individual, however, to make that choice since people also
differ in terms of how risk averse they are.
5. Increasing the investment horizon increases the potential variability of returns, and hence the
range of possible outcomes from the investment. Given that a wider range of values means more
uncertainty about the outcome, from one perspective more time implies more risk.
6. See text discussion under "Partitioning Risk."
Business Risk Variability of sales
Financial Risk Variability of net earnings from financial leverage
Purchasing Power Risk Variability of real return from inflation
Interest Rate Risk Variability of return, given changes in market interest rates
Foreign Exchange Risk Variability of return caused by varying exchange rates in
investment period
Political Risk Variability of return related to change in governmental
decisions
Social Risk Variability of return related to changing consumer and
business reaction to social issues
7. Tobacco investments, environmental protection, sweatshop businesses, child labor laws outside
the U.S.
8. Individual preference.
9. Individual preference.
10. There is a greater difference with annual versus monthly compounding. As the rate of
compounding increases the incremental increase in dollars earned decreases. There is a smaller
difference between daily and continuous compounding compared to going from annual to monthly
compounding.
Loading page 5...
Chapter 2: Risk and Return 5
11. If interest rates are zero, there is no time value to money. As interest rates increase, present values
decrease and future values increase. The higher the interest rate, the greater the “interest on
interest” earned. The more frequent the compounding, the sooner the “interest on interest” resets.
12. $3,355.04 = PV annuity of 8i, 10n, $500 pmt on financial calculator
13 $2,940.12 = PV of $4000FV, 4n, 8i
14. $2,829.13 = PV of $4000FV, 4.5n, 8i
15. $937.50 = PV of $75 payment perpetuity at 8i, 100n, or $75/.08
16. $2,876.41 = PV of $500 annuity (pmt), 10n, 8i, or $3355.04 discounted (enter as a FV) for 2n, 8i
to present. The first payment of this ordinary annuity, received at the end of the third year, must
be discounted back two years.
17. $7,243.28 = FV of 10n, $500 annuity (pmt), 8i
18. $1,469.33 = FV of $1000PV, 5n, 8i
19. $1,485.95 = FV of $1000PV, 5 4 = 20n, 8/4 = 2i
20. $1,491.82 = FV of $1000, 5 years, continuous compounding = .08 x 5 =.40 ex $1000
21. Monthly returns:
January 2004 -0.0200 January 2005 -0.0029
February 2004 0.0051 February 2005 -0.0010
March 2004 0.0051 March 2005 0.0059
April 2004 0.0202 April 2005 0.0078
May 2004 0.0149 May 2005 -0.0048
June 2004 -0.0166 June 2005 -0.0126
July 2004 -0.0030 July 2005 0.0108
August 2004 -0.0010 August 2005 0.0049
September 2004 -0.0090 September 2005 0.0087
October 2004 0.0151 October 2005 -0.0048
November 2004 0.0010 November 2005 0.0029
December 2004 0.0199 December 2005 -0.0087
Mean (all 24 months) = 0.0016 = 0.16%
22. Quarterly Returns
Q1 2004 -0.0100 Q1 2005 0.0020
Q2 2004 0.0182 Q2 2005 -0.0098
Q3 2004 -0.0129 Q3 2005 0.0246
Q4 2004 0.0281 Q4 2005 -0.0106
Mean (8 quarters) = 0.0037 = 0.37%
23. 4.14%
24. 0.000114
25. 0.000299
11. If interest rates are zero, there is no time value to money. As interest rates increase, present values
decrease and future values increase. The higher the interest rate, the greater the “interest on
interest” earned. The more frequent the compounding, the sooner the “interest on interest” resets.
12. $3,355.04 = PV annuity of 8i, 10n, $500 pmt on financial calculator
13 $2,940.12 = PV of $4000FV, 4n, 8i
14. $2,829.13 = PV of $4000FV, 4.5n, 8i
15. $937.50 = PV of $75 payment perpetuity at 8i, 100n, or $75/.08
16. $2,876.41 = PV of $500 annuity (pmt), 10n, 8i, or $3355.04 discounted (enter as a FV) for 2n, 8i
to present. The first payment of this ordinary annuity, received at the end of the third year, must
be discounted back two years.
17. $7,243.28 = FV of 10n, $500 annuity (pmt), 8i
18. $1,469.33 = FV of $1000PV, 5n, 8i
19. $1,485.95 = FV of $1000PV, 5 4 = 20n, 8/4 = 2i
20. $1,491.82 = FV of $1000, 5 years, continuous compounding = .08 x 5 =.40 ex $1000
21. Monthly returns:
January 2004 -0.0200 January 2005 -0.0029
February 2004 0.0051 February 2005 -0.0010
March 2004 0.0051 March 2005 0.0059
April 2004 0.0202 April 2005 0.0078
May 2004 0.0149 May 2005 -0.0048
June 2004 -0.0166 June 2005 -0.0126
July 2004 -0.0030 July 2005 0.0108
August 2004 -0.0010 August 2005 0.0049
September 2004 -0.0090 September 2005 0.0087
October 2004 0.0151 October 2005 -0.0048
November 2004 0.0010 November 2005 0.0029
December 2004 0.0199 December 2005 -0.0087
Mean (all 24 months) = 0.0016 = 0.16%
22. Quarterly Returns
Q1 2004 -0.0100 Q1 2005 0.0020
Q2 2004 0.0182 Q2 2005 -0.0098
Q3 2004 -0.0129 Q3 2005 0.0246
Q4 2004 0.0281 Q4 2005 -0.0106
Mean (8 quarters) = 0.0037 = 0.37%
23. 4.14%
24. 0.000114
25. 0.000299
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6
Chapter 3
The Marketplace
OUTLINE
Introduction
The Role of the Capital Markets
Economic Function
Continuous Pricing Function
Fair Pricing Function
The Exchanges
National Exchanges
Regional Exchanges
Trading Systems
Circuit Breakers and Trading Curbs
The Nasdaq Stock Market
The Small Order Execution System (SOES)
The Nasdaq National Market
The Nasdaq Small-Cap Market
The Over-The-Counter Market
Over-the-Counter Bulletin Board (OTCBB)
Pink Sheet Stocks
Third and Fourth Markets
Regulation
The Exchanges
The SEC
The NASD
SIPC
Ethics
Illegal vs. Unethical
The Chartered Financial Analyst Program
The CFA Program Exams
Standards of Professional Conduct
SUMMARY
The capital markets serve three primary functions. The economic function brings buyers and
sellers together. The continuous pricing function enables traders to get market prices quickly. The
fair pricing function is related to the continuous pricing function and assures both buyers and
sellers of getting a market-determined price when they trade.
The two national exchanges in the United States are the New York Stock Exchange and the
American Stock Exchange. Five other smaller exchanges are known as regional exchanges.
Worldwide, approximately 150 exchanges exist in more than 50 countries.
Many securities trade in the Nasdaq system or in the over-the-counter market. In this electronic
linkup of brokerage firms, brokers and institutional investors place orders by computer. Some very
large companies are National Market Issues, with smaller firms listed as small-cap stocks. The
over-the-counter market is distinct from the Nasdaq Stock Market. OTC securities trade either as
OTC Bulletin Board stocks or as Pink Sheet issues.
Chapter 3
The Marketplace
OUTLINE
Introduction
The Role of the Capital Markets
Economic Function
Continuous Pricing Function
Fair Pricing Function
The Exchanges
National Exchanges
Regional Exchanges
Trading Systems
Circuit Breakers and Trading Curbs
The Nasdaq Stock Market
The Small Order Execution System (SOES)
The Nasdaq National Market
The Nasdaq Small-Cap Market
The Over-The-Counter Market
Over-the-Counter Bulletin Board (OTCBB)
Pink Sheet Stocks
Third and Fourth Markets
Regulation
The Exchanges
The SEC
The NASD
SIPC
Ethics
Illegal vs. Unethical
The Chartered Financial Analyst Program
The CFA Program Exams
Standards of Professional Conduct
SUMMARY
The capital markets serve three primary functions. The economic function brings buyers and
sellers together. The continuous pricing function enables traders to get market prices quickly. The
fair pricing function is related to the continuous pricing function and assures both buyers and
sellers of getting a market-determined price when they trade.
The two national exchanges in the United States are the New York Stock Exchange and the
American Stock Exchange. Five other smaller exchanges are known as regional exchanges.
Worldwide, approximately 150 exchanges exist in more than 50 countries.
Many securities trade in the Nasdaq system or in the over-the-counter market. In this electronic
linkup of brokerage firms, brokers and institutional investors place orders by computer. Some very
large companies are National Market Issues, with smaller firms listed as small-cap stocks. The
over-the-counter market is distinct from the Nasdaq Stock Market. OTC securities trade either as
OTC Bulletin Board stocks or as Pink Sheet issues.
Loading page 7...
Chapter 3 The Marketplace 7
The initial sale of shares occurs in the primary market. Subsequently, they trade in the secondary market.
The sale of listed securities via the Nasdaq system is called the third market, while direct institutional trading
via the Instinet system is the fourth market.
Numerous organizations regulate the securities industry. The most important pieces of
legislation are the Securities Act of 1933 and the Securities Exchange Act of 1934, which
significantly improved the required level of financial disclosure for public securities. The Securities
Investor Protection Corporation provides protection against fraud or brokerage firm failure.
The Chartered Financial Analyst (CFA) designation is a prestigious credential for those
involved in the money management business. In many businesses, enrollment in the CFA program
is a prerequisite for employment.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. The continuous pricing function refers to the fact that current prices are routinely determined
and easily accessible through print media or electronically. The fair price function refers to the
fact that the substantial number of market participants gives assurance that the prevailing price
for an exchange traded security is a fairly determined price.
2. By making it easy to buy and sell securities, money (capital) flows easily and generally without
barrier from sources to uses.
3. The primary market is the sale of securities for the first time, as when Detroit sells new
automobiles to a car dealer. The secondary market is the resale of existing shares, as when
used cars sell through a newspaper classified advertisement.
4. The specialist system ensures that all buyers and sellers present their prices at the same
location. This makes it easy to determine what is the “best” price regardless of the transaction
an investor wishes to make.
5. You must be a member of an exchange in order to go there and make a trade. Most individuals
are not members. They must hire someone (a broker) to make the trade for them.
6. Dual listing is when a security trades on either the NYSE or the AMEX plus one or more of the
regional exchanges.
7. The specialist is charged with making a “fair and orderly market” in his or her assigned
securities. A good measure of such a market is one in which the bid/ask spread is small.
8. The bid price is the highest price anyone has indicated they will pay for a security. The ask
price is the lowest selling price. The spread is the mathematical difference between the bid
price and the ask price. (The spread is always expressed as a positive number.)
9. A specialist system has one single person through whom all trades must pass. In a market
maker system, numerous individuals simultaneously have the opportunity to attempt to get the
opposite side of a trade arriving at the exchange.
10. The SuperDot system is an electronic trading aid that permits certain trades to be electronically
routed to the specialist’s post rather than be hand carried. About 85% of all orders reach the
specialist via this system.
The initial sale of shares occurs in the primary market. Subsequently, they trade in the secondary market.
The sale of listed securities via the Nasdaq system is called the third market, while direct institutional trading
via the Instinet system is the fourth market.
Numerous organizations regulate the securities industry. The most important pieces of
legislation are the Securities Act of 1933 and the Securities Exchange Act of 1934, which
significantly improved the required level of financial disclosure for public securities. The Securities
Investor Protection Corporation provides protection against fraud or brokerage firm failure.
The Chartered Financial Analyst (CFA) designation is a prestigious credential for those
involved in the money management business. In many businesses, enrollment in the CFA program
is a prerequisite for employment.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. The continuous pricing function refers to the fact that current prices are routinely determined
and easily accessible through print media or electronically. The fair price function refers to the
fact that the substantial number of market participants gives assurance that the prevailing price
for an exchange traded security is a fairly determined price.
2. By making it easy to buy and sell securities, money (capital) flows easily and generally without
barrier from sources to uses.
3. The primary market is the sale of securities for the first time, as when Detroit sells new
automobiles to a car dealer. The secondary market is the resale of existing shares, as when
used cars sell through a newspaper classified advertisement.
4. The specialist system ensures that all buyers and sellers present their prices at the same
location. This makes it easy to determine what is the “best” price regardless of the transaction
an investor wishes to make.
5. You must be a member of an exchange in order to go there and make a trade. Most individuals
are not members. They must hire someone (a broker) to make the trade for them.
6. Dual listing is when a security trades on either the NYSE or the AMEX plus one or more of the
regional exchanges.
7. The specialist is charged with making a “fair and orderly market” in his or her assigned
securities. A good measure of such a market is one in which the bid/ask spread is small.
8. The bid price is the highest price anyone has indicated they will pay for a security. The ask
price is the lowest selling price. The spread is the mathematical difference between the bid
price and the ask price. (The spread is always expressed as a positive number.)
9. A specialist system has one single person through whom all trades must pass. In a market
maker system, numerous individuals simultaneously have the opportunity to attempt to get the
opposite side of a trade arriving at the exchange.
10. The SuperDot system is an electronic trading aid that permits certain trades to be electronically
routed to the specialist’s post rather than be hand carried. About 85% of all orders reach the
specialist via this system.
Loading page 8...
Chapter 3 The Marketplace8
11. The Nasdaq stock market is a worldwide, computerized linkup of brokerage firms,
investment houses, and large commercial banks for the purpose of trading listed securities.
The OTC market refers to the trading of securities not listed on the Nasdaq or a
national/regional securities exchange.
12. A pink sheet stock is an over-the-counter security about which little information is generally
available. They get their name from the long pink sheets of paper that, in years past, would
hang on a brokerage firm office and show the names of firms that made a market in the
shares. Today the “pink sheet” is electronic and available over the Internet.
13. The third market is over-the-counter trading of a security that trades on either the New
York Stock Exchange or the American Stock Exchange. The fourth market is direct
institutional trading, usually between large banks, insurance companies, or pension funds.
14. The Securities and Exchange Commission seeks to promote “honest and open securities
markets.” It also seeks “full and fair disclosure” of corporate information to potential
investors.
15. A Ponzi scheme is an illegal activity in which a scam artist accepts “investments” from
people and later returns part of their principal investment, claiming it is income or other
profits. The Ponzi scheme is dependent on new deposits to remain in operation.
16. The Securities Act of 1933 provides for the regulation of the initial sale of securities in the
primary market. The Security Exchange Act of 1934 provides for the regulation of the
secondary market (the trading at the exchanges.)
17. The SIPC protects investors against loss due to brokerage firm failure, fraud, theft, or loss
due to natural disaster. It does not provide protection against bad investment decisions.
18. The CFA Code of Ethics is a general statement of ethical conduct to which members of the
CFA Institute subscribe. The Standards of Professional Conduct stem directly from the
Code of Ethics, but are more detailed statements about dealings with the profession, the
employer, the client, and the investing public.
11. The Nasdaq stock market is a worldwide, computerized linkup of brokerage firms,
investment houses, and large commercial banks for the purpose of trading listed securities.
The OTC market refers to the trading of securities not listed on the Nasdaq or a
national/regional securities exchange.
12. A pink sheet stock is an over-the-counter security about which little information is generally
available. They get their name from the long pink sheets of paper that, in years past, would
hang on a brokerage firm office and show the names of firms that made a market in the
shares. Today the “pink sheet” is electronic and available over the Internet.
13. The third market is over-the-counter trading of a security that trades on either the New
York Stock Exchange or the American Stock Exchange. The fourth market is direct
institutional trading, usually between large banks, insurance companies, or pension funds.
14. The Securities and Exchange Commission seeks to promote “honest and open securities
markets.” It also seeks “full and fair disclosure” of corporate information to potential
investors.
15. A Ponzi scheme is an illegal activity in which a scam artist accepts “investments” from
people and later returns part of their principal investment, claiming it is income or other
profits. The Ponzi scheme is dependent on new deposits to remain in operation.
16. The Securities Act of 1933 provides for the regulation of the initial sale of securities in the
primary market. The Security Exchange Act of 1934 provides for the regulation of the
secondary market (the trading at the exchanges.)
17. The SIPC protects investors against loss due to brokerage firm failure, fraud, theft, or loss
due to natural disaster. It does not provide protection against bad investment decisions.
18. The CFA Code of Ethics is a general statement of ethical conduct to which members of the
CFA Institute subscribe. The Standards of Professional Conduct stem directly from the
Code of Ethics, but are more detailed statements about dealings with the profession, the
employer, the client, and the investing public.
Loading page 9...
9
Chapter 4
Bond Fundamentals
OUTLINE
Introduction
Bond Principles
Identification of Bonds
Classification of Bonds
Terms of Repayment
Bond Cash Flows
Convertible and Exchangeable Bonds
Registration
The Financial Page Listing
Basic Information
Footnotes
Government Bonds
Bond Pricing and Returns
Valuation Equations
Yield to Maturity
Spot Rates
Realized Compound Yield
Current Yield
Accrued Interest
Bond Risks
Price Risks
Convenience Risks
SUMMARY
Bonds are identified by their issuer, their coupon, and their maturity year. They are classified
according to the nature of the issuer and according to the security behind them. Some bonds
provide a conversion feature whereby they can be exchanged for another asset - usually shares of
common stock in the issuing corporation. The bond indenture spells out the details.
The income stream associated with most bonds contains two components: an annuity stream and
a single sum to be received in the future. The discount rate that equates the present value of the
future cash flows with the current price of the bond is the bond’s yield to maturity, which is
identical to the internal rate of return.
A major assumption of the yield to maturity calculation is the requirement that coupon proceeds
be reinvested at the bond’s yield to maturity. If the reinvestment rate is different from the bond’s
rate, the rate of return ultimately realized will be different. By tradition, bond yield to maturity is
based on semiannual compounding.
When comparing bonds with other investments, the effective annual yield (or realized
compound yield) should be used to make a realistic comparison. The yield curve shows the
relationship between yield and time until maturity. Bonds accrue interest each day they are held.
Bond prices are expressed as a percentage of par value. Corporate bonds usually trade in
minimum price increments of 1⁄8%, while government bonds trade in 32nds.
Chapter 4
Bond Fundamentals
OUTLINE
Introduction
Bond Principles
Identification of Bonds
Classification of Bonds
Terms of Repayment
Bond Cash Flows
Convertible and Exchangeable Bonds
Registration
The Financial Page Listing
Basic Information
Footnotes
Government Bonds
Bond Pricing and Returns
Valuation Equations
Yield to Maturity
Spot Rates
Realized Compound Yield
Current Yield
Accrued Interest
Bond Risks
Price Risks
Convenience Risks
SUMMARY
Bonds are identified by their issuer, their coupon, and their maturity year. They are classified
according to the nature of the issuer and according to the security behind them. Some bonds
provide a conversion feature whereby they can be exchanged for another asset - usually shares of
common stock in the issuing corporation. The bond indenture spells out the details.
The income stream associated with most bonds contains two components: an annuity stream and
a single sum to be received in the future. The discount rate that equates the present value of the
future cash flows with the current price of the bond is the bond’s yield to maturity, which is
identical to the internal rate of return.
A major assumption of the yield to maturity calculation is the requirement that coupon proceeds
be reinvested at the bond’s yield to maturity. If the reinvestment rate is different from the bond’s
rate, the rate of return ultimately realized will be different. By tradition, bond yield to maturity is
based on semiannual compounding.
When comparing bonds with other investments, the effective annual yield (or realized
compound yield) should be used to make a realistic comparison. The yield curve shows the
relationship between yield and time until maturity. Bonds accrue interest each day they are held.
Bond prices are expressed as a percentage of par value. Corporate bonds usually trade in
minimum price increments of 1⁄8%, while government bonds trade in 32nds.
Loading page 10...
Chapter 4 Bond Fundamentals10
Bond risk falls into two major classifications. Price risks refer to the chance of monetary loss
due to (1) the likelihood of the firm defaulting on its loan payments (default risk), and (2) the
variability of interest rates (interest rate risk). Convenience risks reflect additional demands on
management time because of bonds being called by their issuer, because of the need to reinvest
interest received, or because of poor marketability of a particular issue. Many bonds have a period
of call protection and subsequently a declining call premium.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. No. Because the cash flows vary through time, they can only be estimated, which means the
yield to maturity is also merely an estimate.
2. If neither is callable, these securities should sell for the same price. They are equivalent
financial claims, providing the same income stream from the same issuer, and with the same
degree of risk.
3. The statement is generally true. You would like to know, however, details of the call feature, if
any, and whether or not the period of call protection had expired.
4. A Treasury bond has an initial life greater than 10 years. A Treasury note has an initial life
from 2 - 10 years.
5. Default risk is the same as credit risk. It is important to an investor, as it measures the
likelihood the security issuer will be able to provide the promised cash flow stream.
6. The call of a bond is not always good news. Once called, the bond ceases to earn interest and
must be replaced with some other security to remain an income producing investment. This
can be inconvenient and involve trading fees.
7. Accrued interest results in an investor earning one day’s worth of interest for every day he or
she owns the bond. There is no important investment consideration surrounding the interest
payment dates.
8. Lowering the bond rating means it has increased default risk. Potential investors will now
require a higher expected return. This means the bond price will fall.
9. The realized compound rate is the same concept as the effective annual rate. The yield to
maturity is typically calculated assuming semi-annual interest payments. When compounding
occurs more frequently, the realized compound rate will exceed the yield to maturity, and vice
versa.
10. The coupon payments must be reinvested, and the future reinvestment rate is unobservable.
If these payments earn any rate other than the original 14%, the ultimate return to the investor
will be different than 14%.
11. The five-year CD pays97.552,1$)
2
09.1(*000,1$ 10 =+ . The 4.5-year CD pays40.518,1$)
2
095.1(*000,1$ 9 =+
. The difference in interest paid is $1,552.97 − $1,518.40 =
$34.57.
Bond risk falls into two major classifications. Price risks refer to the chance of monetary loss
due to (1) the likelihood of the firm defaulting on its loan payments (default risk), and (2) the
variability of interest rates (interest rate risk). Convenience risks reflect additional demands on
management time because of bonds being called by their issuer, because of the need to reinvest
interest received, or because of poor marketability of a particular issue. Many bonds have a period
of call protection and subsequently a declining call premium.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. No. Because the cash flows vary through time, they can only be estimated, which means the
yield to maturity is also merely an estimate.
2. If neither is callable, these securities should sell for the same price. They are equivalent
financial claims, providing the same income stream from the same issuer, and with the same
degree of risk.
3. The statement is generally true. You would like to know, however, details of the call feature, if
any, and whether or not the period of call protection had expired.
4. A Treasury bond has an initial life greater than 10 years. A Treasury note has an initial life
from 2 - 10 years.
5. Default risk is the same as credit risk. It is important to an investor, as it measures the
likelihood the security issuer will be able to provide the promised cash flow stream.
6. The call of a bond is not always good news. Once called, the bond ceases to earn interest and
must be replaced with some other security to remain an income producing investment. This
can be inconvenient and involve trading fees.
7. Accrued interest results in an investor earning one day’s worth of interest for every day he or
she owns the bond. There is no important investment consideration surrounding the interest
payment dates.
8. Lowering the bond rating means it has increased default risk. Potential investors will now
require a higher expected return. This means the bond price will fall.
9. The realized compound rate is the same concept as the effective annual rate. The yield to
maturity is typically calculated assuming semi-annual interest payments. When compounding
occurs more frequently, the realized compound rate will exceed the yield to maturity, and vice
versa.
10. The coupon payments must be reinvested, and the future reinvestment rate is unobservable.
If these payments earn any rate other than the original 14%, the ultimate return to the investor
will be different than 14%.
11. The five-year CD pays97.552,1$)
2
09.1(*000,1$ 10 =+ . The 4.5-year CD pays40.518,1$)
2
095.1(*000,1$ 9 =+
. The difference in interest paid is $1,552.97 − $1,518.40 =
$34.57.
Loading page 11...
Chapter 4 Bond Fundamentals 11
12. Solve for P0 :P t
t
0
1
14
14
40
1 09152
1000
1 09152
50= + + + =
=
( . ) ( . ) $941.
13. a. This bond will double in price in eight years. Using the Rule of 72, its yield to maturity
should be about 72/8 = 9%.
b.500 1000
1 2 16
= +( )r r = 8.85%
14. a.= +
+
+
=
7
1
7
)(1
$1,000
)(1
$100
$800 rr r = 14.77%
b.= +
+
+
=
14
1 14
)
2
1(
000,1$
)
2
1(
50$
800$ t t rr r = 14.67%
15.$72. $8.50 43
360 66
= per $1,000 par value
16.$750 $37.
( )
$1,
( )
= + + +=
50
1 2
000
1 21
42
42r rt
t
r = 10.46%$37.
( . ) $632.
50
1 10462
75
1
42
+ =
=
t
t84.37%
$750
$632.75 =
17.1 135
12 1 14 37%
12
+
− =
. .
18 - 19 Individual response
20. There is a difference between 10% simple interest (what Jones is referring to) and a compound
annual growth rate of 10% (Smith’s perspective, which is what he earned if $10,000 grew to
$16,105.10 in five years). Both individuals are correct.
21. The interest per day on $5,000 par is (7.25%)($5,000)/360 = $1.01. When he buys the bonds
he pays accrued interest of (30 + 8)($1.01) = $38.38. On October 1 he receives an interest
check for (0.0725/2)($5,000) = $181.25. When he sells the bonds, he receives accrued interest
of (30)($1.01) = $30.30.
interest check received $181.25
accrued interest received $30.30
minus accrued interest paid −$38.18
Total $173.17
12. Solve for P0 :P t
t
0
1
14
14
40
1 09152
1000
1 09152
50= + + + =
=
( . ) ( . ) $941.
13. a. This bond will double in price in eight years. Using the Rule of 72, its yield to maturity
should be about 72/8 = 9%.
b.500 1000
1 2 16
= +( )r r = 8.85%
14. a.= +
+
+
=
7
1
7
)(1
$1,000
)(1
$100
$800 rr r = 14.77%
b.= +
+
+
=
14
1 14
)
2
1(
000,1$
)
2
1(
50$
800$ t t rr r = 14.67%
15.$72. $8.50 43
360 66
= per $1,000 par value
16.$750 $37.
( )
$1,
( )
= + + +=
50
1 2
000
1 21
42
42r rt
t
r = 10.46%$37.
( . ) $632.
50
1 10462
75
1
42
+ =
=
t
t84.37%
$750
$632.75 =
17.1 135
12 1 14 37%
12
+
− =
. .
18 - 19 Individual response
20. There is a difference between 10% simple interest (what Jones is referring to) and a compound
annual growth rate of 10% (Smith’s perspective, which is what he earned if $10,000 grew to
$16,105.10 in five years). Both individuals are correct.
21. The interest per day on $5,000 par is (7.25%)($5,000)/360 = $1.01. When he buys the bonds
he pays accrued interest of (30 + 8)($1.01) = $38.38. On October 1 he receives an interest
check for (0.0725/2)($5,000) = $181.25. When he sells the bonds, he receives accrued interest
of (30)($1.01) = $30.30.
interest check received $181.25
accrued interest received $30.30
minus accrued interest paid −$38.18
Total $173.17
Loading page 12...
Chapter 4 Bond Fundamentals12
22 a. It is important to recognize that the concept of “portfolio yield to maturity” is fuzzy when
the securities in a portfolio do not have a common maturity. Still, it is possible to calculate the
portfolio internal rate of return, which is what must be done in this circumstance. Assuming
annual coupons for simplicity, the valuation equation looks as follows.$2, $100 $110
( )
$100 $1,
( )
$100
( )
$1,
( )
000 1
100
1 1
100
12 3 4= +
+ + +
+ + + + +r r r r
Solving for r, we get 10.19%.
b. If the securities have a common maturity, the portfolio yield to maturity will be close to the
average of the two single security yields to maturity.
23. The put feature on the bond functions as a floor value below which the bond will not sell.
Regardless of how high interest rates might rise, the bond can always be returned to the issuer
for the put price.
24. The entry of 98:23 means 98 and 23/32 percent of par. On $5,000 par value, this is a purchase
price of 98.7188% of $5,000, or $4,935.94.
25. It fell by 11/32% of par, or $85.94.
26. B.
27. B. (Because the bond sells at a discount, the return will be greater than the coupon, but less
than the yield to maturity because the coupon proceeds are reinvested at a lower rate.)
28. A. With more frequent compounding, the nominal interest rate declines.
29. If a bond’s yield to maturity is less than its coupon, the bond must be selling at a premium. As
the bond’s maturity date approaches, the bond price will approach par, which in this case
means it will decline.
30. a. It is difficult to compare the reinvestment rate risk without knowing the bond coupons. All
else being equal, the higher priced bond would have the higher coupon, so it would be the best
guess.
b. Bonds selling at a discount are seldom called; the 120% bond would have more call risk.
c. Without knowing more details it is not possible to be conclusive in assessing the relative
interest rate risk of these two bonds. The bond selling for the greatest deviation from par value
is likely to have the greatest price volatility, everything else being equal. The 70% bond
probably has the most interest rate risk.
31. (CFA Guideline Answers; reprinted with permission).
A. A sinking fund is a provision that calls for the mandatory early redemption of a bond issue.
The provision may be for a specific number of bonds or a percentage of bonds over a specified
time horizon. The sinking fund can retire all or a portion of an issue over its life.
22 a. It is important to recognize that the concept of “portfolio yield to maturity” is fuzzy when
the securities in a portfolio do not have a common maturity. Still, it is possible to calculate the
portfolio internal rate of return, which is what must be done in this circumstance. Assuming
annual coupons for simplicity, the valuation equation looks as follows.$2, $100 $110
( )
$100 $1,
( )
$100
( )
$1,
( )
000 1
100
1 1
100
12 3 4= +
+ + +
+ + + + +r r r r
Solving for r, we get 10.19%.
b. If the securities have a common maturity, the portfolio yield to maturity will be close to the
average of the two single security yields to maturity.
23. The put feature on the bond functions as a floor value below which the bond will not sell.
Regardless of how high interest rates might rise, the bond can always be returned to the issuer
for the put price.
24. The entry of 98:23 means 98 and 23/32 percent of par. On $5,000 par value, this is a purchase
price of 98.7188% of $5,000, or $4,935.94.
25. It fell by 11/32% of par, or $85.94.
26. B.
27. B. (Because the bond sells at a discount, the return will be greater than the coupon, but less
than the yield to maturity because the coupon proceeds are reinvested at a lower rate.)
28. A. With more frequent compounding, the nominal interest rate declines.
29. If a bond’s yield to maturity is less than its coupon, the bond must be selling at a premium. As
the bond’s maturity date approaches, the bond price will approach par, which in this case
means it will decline.
30. a. It is difficult to compare the reinvestment rate risk without knowing the bond coupons. All
else being equal, the higher priced bond would have the higher coupon, so it would be the best
guess.
b. Bonds selling at a discount are seldom called; the 120% bond would have more call risk.
c. Without knowing more details it is not possible to be conclusive in assessing the relative
interest rate risk of these two bonds. The bond selling for the greatest deviation from par value
is likely to have the greatest price volatility, everything else being equal. The 70% bond
probably has the most interest rate risk.
31. (CFA Guideline Answers; reprinted with permission).
A. A sinking fund is a provision that calls for the mandatory early redemption of a bond issue.
The provision may be for a specific number of bonds or a percentage of bonds over a specified
time horizon. The sinking fund can retire all or a portion of an issue over its life.
Loading page 13...
Chapter 4 Bond Fundamentals 13
B. (i) Compared to a bond without a sinking fund, the sinking fund will reduce the average
maturity of the overall issue, and therefore shorten the effective final maturity or average life.
(ii) The company will make the same total principal payments over the life of the issue,
although the timing of the payments will be affected. The total interest payments associated
with the issue will be reduced given the early redemption of principal.
C. From the investor’s point of view, the key reason for demanding a sinking fund is to reduce the
principal risk at maturity. Default risk is reduced by the orderly retirement of the issue. Also,
the investor may be looking to reduce the expected life and therefore the expected price
volatility of the issue. Downside protection is further provided by the existence of a forced
buyer (the issuer for sinking fund requirements) regardless of market conditions.
D. The call protection provision is absolute protection for an investor, preventing the company
from redeeming an issue short of the call date or maturity date. Refunding protection is less
restrictive. With refunding protection, the company is prohibited from redeeming an issue with
lower cost debt ranking equally or superior to the debt being redeemed. The issue can still be
called using other sources of funds such as retained earnings common stock, or sale of
property. Several recent cases illustrate the general ineffectiveness of refunding protection in
the real world.
32. First solve for the yield to maturity of the step-down bond by solving the following equation.15
14
2 )1(
25.107
)1(
25.7
1
50.8
5.99 rrr t
t +
+
+
+
+
= =
r = 7.44%
Then solve for P0 in this equation:15
14
2
0 )0744.1(
50.108
)0744.1(
50.8
0744.1
25.7
P +
+
+
+
+
= =t
t
= 108.23 or $1,082.30
B. (i) Compared to a bond without a sinking fund, the sinking fund will reduce the average
maturity of the overall issue, and therefore shorten the effective final maturity or average life.
(ii) The company will make the same total principal payments over the life of the issue,
although the timing of the payments will be affected. The total interest payments associated
with the issue will be reduced given the early redemption of principal.
C. From the investor’s point of view, the key reason for demanding a sinking fund is to reduce the
principal risk at maturity. Default risk is reduced by the orderly retirement of the issue. Also,
the investor may be looking to reduce the expected life and therefore the expected price
volatility of the issue. Downside protection is further provided by the existence of a forced
buyer (the issuer for sinking fund requirements) regardless of market conditions.
D. The call protection provision is absolute protection for an investor, preventing the company
from redeeming an issue short of the call date or maturity date. Refunding protection is less
restrictive. With refunding protection, the company is prohibited from redeeming an issue with
lower cost debt ranking equally or superior to the debt being redeemed. The issue can still be
called using other sources of funds such as retained earnings common stock, or sale of
property. Several recent cases illustrate the general ineffectiveness of refunding protection in
the real world.
32. First solve for the yield to maturity of the step-down bond by solving the following equation.15
14
2 )1(
25.107
)1(
25.7
1
50.8
5.99 rrr t
t +
+
+
+
+
= =
r = 7.44%
Then solve for P0 in this equation:15
14
2
0 )0744.1(
50.108
)0744.1(
50.8
0744.1
25.7
P +
+
+
+
+
= =t
t
= 108.23 or $1,082.30
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14
Chapter 5
Common Stock
OUTLINE
Introduction
Corporations, Shares, and Shareholder Rights
Corporations
Shares
Shareholder Rights
The Mystique of Dividends
Types of Dividends
Special Distributions
The Dividend Payment Procedure
Why Dividends Do Not Matter
Stock Splits
Forward and Reverse Splits
Why Stock Splits Do Not Matter
Why Firms Split Their Stock
Stock Splits vs. Stock Dividends
The Financial Page Listing
The Basic Information
Footnotes and Symbols
Categories of Stock
Blue Chip Stocks
Income Stocks
Cyclical Stocks
Defensive Stocks
Growth Stocks
Speculative Stocks
Penny Stocks
Category Overlap
A Note on Stock Symbols
SUMMARY
Dividends are an important part of the investment business, but not because they instantly increase
an investor’s wealth. Dividends do not grow on trees; they come from the issuer’s checking account
and reduce the value of the firm when they are paid. Dividends do provide current income, but they do
so at the expense of future growth.
A precise chronology of events surrounds the payment of a dividend. The ex-dividend date
convention eliminates uncertainty regarding entitlement to forthcoming dividends.
Stock splits, like dividends, also do not alter the collective wealth of the shareholders. They are
analogous to cutting pieces of a pie into smaller slices. The total quantity of pie does not change as the
serving size changes.
Stocks are grouped into largely subjective categories including blue chip, growth, income,
defensive, cyclical, speculative, and penny stocks. These categories are not mutually exclusive, nor are
they precise.
Chapter 5
Common Stock
OUTLINE
Introduction
Corporations, Shares, and Shareholder Rights
Corporations
Shares
Shareholder Rights
The Mystique of Dividends
Types of Dividends
Special Distributions
The Dividend Payment Procedure
Why Dividends Do Not Matter
Stock Splits
Forward and Reverse Splits
Why Stock Splits Do Not Matter
Why Firms Split Their Stock
Stock Splits vs. Stock Dividends
The Financial Page Listing
The Basic Information
Footnotes and Symbols
Categories of Stock
Blue Chip Stocks
Income Stocks
Cyclical Stocks
Defensive Stocks
Growth Stocks
Speculative Stocks
Penny Stocks
Category Overlap
A Note on Stock Symbols
SUMMARY
Dividends are an important part of the investment business, but not because they instantly increase
an investor’s wealth. Dividends do not grow on trees; they come from the issuer’s checking account
and reduce the value of the firm when they are paid. Dividends do provide current income, but they do
so at the expense of future growth.
A precise chronology of events surrounds the payment of a dividend. The ex-dividend date
convention eliminates uncertainty regarding entitlement to forthcoming dividends.
Stock splits, like dividends, also do not alter the collective wealth of the shareholders. They are
analogous to cutting pieces of a pie into smaller slices. The total quantity of pie does not change as the
serving size changes.
Stocks are grouped into largely subjective categories including blue chip, growth, income,
defensive, cyclical, speculative, and penny stocks. These categories are not mutually exclusive, nor are
they precise.
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Chapter 5: Common Stock 15
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. A stock dividend merely increases the number of outstanding shares of stock. It does nothing to
increase the assets or equity of the firm. After payment of the stock dividend, the shareholder
holds more shares, but they are worth proportionately less.
2. There are issuance costs such as clerical time, postage, and the printing of stock certificates
associated with paying a stock dividend. Because a stock dividend does not increase the
shareholders’ wealth, it seems economically unsound to pay such a dividend. However,
shareholders seem to like them, and there is a value to this positive perception.
3. A property dividend and a cash dividend both reduce the corporation’s assets. They should both
result in a reduced share price. One difference, however, lies in the fact that the market value of
cash is clear; the market value of the distributed property is less clear. As a consequence, the
stock price decline after a property dividend is probably harder to predict.
4. The statement is turned around. Theoretically, dividends do not affect shareholder wealth.
Dividend policy is important, however, as it may signal information about the future to the
shareholders. Firms do not raise dividends unless they believe the increased dividend can be
sustained. A board of directors should not be flippant with its dividend policy.
5. You could plot the price performance of GT against that of a market index like the S&P500 and
visually inspect the relationship. Even better, perhaps, would be a comparison of GT with some
measure of the economy such as Gross Domestic Product. With a cyclical stock, you would
expect to see the stock performance follow the overall economy.
6. If the financial trouble was unanticipated, the stock price would likely decline because of the
adverse signal from management. On the other hand, if the company’s troubles were well known,
the marketplace might cheer the decision to retain funds and vote positively by holding the stock
price constant or even bidding it up.
7. Investors like a predictable dividend pattern. Also, a managerial decision to reduce dividends is an
adverse signal that is likely to reduce share value. Management wants to act in such a way as to
maximize shareholder wealth.
8. A right is like a ticket to the game. You can 1) exercise it and go to the game (buy more shares),
2) sell the ticket (sell the rights in the secondary market), or 3) stay home and watch the game on
TV (allow the rights to expire unexercised.)
9. The board of directors wants to maximize shareholder wealth. This is not the same as maximizing
the stock price. Investors would prefer to have two shares worth $30 each rather than a single
share worth $50. You can say that the firm wants to maximize share value, but only if you add the
caveat that the number of shares remains constant.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. A stock dividend merely increases the number of outstanding shares of stock. It does nothing to
increase the assets or equity of the firm. After payment of the stock dividend, the shareholder
holds more shares, but they are worth proportionately less.
2. There are issuance costs such as clerical time, postage, and the printing of stock certificates
associated with paying a stock dividend. Because a stock dividend does not increase the
shareholders’ wealth, it seems economically unsound to pay such a dividend. However,
shareholders seem to like them, and there is a value to this positive perception.
3. A property dividend and a cash dividend both reduce the corporation’s assets. They should both
result in a reduced share price. One difference, however, lies in the fact that the market value of
cash is clear; the market value of the distributed property is less clear. As a consequence, the
stock price decline after a property dividend is probably harder to predict.
4. The statement is turned around. Theoretically, dividends do not affect shareholder wealth.
Dividend policy is important, however, as it may signal information about the future to the
shareholders. Firms do not raise dividends unless they believe the increased dividend can be
sustained. A board of directors should not be flippant with its dividend policy.
5. You could plot the price performance of GT against that of a market index like the S&P500 and
visually inspect the relationship. Even better, perhaps, would be a comparison of GT with some
measure of the economy such as Gross Domestic Product. With a cyclical stock, you would
expect to see the stock performance follow the overall economy.
6. If the financial trouble was unanticipated, the stock price would likely decline because of the
adverse signal from management. On the other hand, if the company’s troubles were well known,
the marketplace might cheer the decision to retain funds and vote positively by holding the stock
price constant or even bidding it up.
7. Investors like a predictable dividend pattern. Also, a managerial decision to reduce dividends is an
adverse signal that is likely to reduce share value. Management wants to act in such a way as to
maximize shareholder wealth.
8. A right is like a ticket to the game. You can 1) exercise it and go to the game (buy more shares),
2) sell the ticket (sell the rights in the secondary market), or 3) stay home and watch the game on
TV (allow the rights to expire unexercised.)
9. The board of directors wants to maximize shareholder wealth. This is not the same as maximizing
the stock price. Investors would prefer to have two shares worth $30 each rather than a single
share worth $50. You can say that the firm wants to maximize share value, but only if you add the
caveat that the number of shares remains constant.
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Chapter 5. Common Stock16
10.
Date Event New Shares Total Shares
beginning of 1975 1,000
1976 10% stock dividend 100 1,100
1977 10% stock dividend 110 1,210
1978 5 for 4 stock split 302* 1,512
1979 100% stock dividend 1,512 3,024
1984 2-for-1 stock split 3,024 6,048
1995 4-for-1 stock split 18,144 24,192
* Plus 0.5 shares in cash
11. Student response.
12.
GE General Electric (NYSE)
AERTA Advanced Environmental Recycling
Technologies Inc. (Nasdaq)
TGI Triumph Group, Inc. (NYSE)
MWD Not A Valid Ticker Symbol
NATR Nature’s Sunshine Products (Nasdaq)
A good Internet symbol database is at http://www.stockcenter.com/symlook/symlook.htm.
13. Because the shareholders collectively own the company, it seems that no distribution, even one in
error, should increase their wealth. In fact, given that this was a screw-up with associated
administrative costs, it may very well have reduced shareholder wealth across the board. Certainly
it should not have been a windfall gain as first impression might suggest.
10.
Date Event New Shares Total Shares
beginning of 1975 1,000
1976 10% stock dividend 100 1,100
1977 10% stock dividend 110 1,210
1978 5 for 4 stock split 302* 1,512
1979 100% stock dividend 1,512 3,024
1984 2-for-1 stock split 3,024 6,048
1995 4-for-1 stock split 18,144 24,192
* Plus 0.5 shares in cash
11. Student response.
12.
GE General Electric (NYSE)
AERTA Advanced Environmental Recycling
Technologies Inc. (Nasdaq)
TGI Triumph Group, Inc. (NYSE)
MWD Not A Valid Ticker Symbol
NATR Nature’s Sunshine Products (Nasdaq)
A good Internet symbol database is at http://www.stockcenter.com/symlook/symlook.htm.
13. Because the shareholders collectively own the company, it seems that no distribution, even one in
error, should increase their wealth. In fact, given that this was a screw-up with associated
administrative costs, it may very well have reduced shareholder wealth across the board. Certainly
it should not have been a windfall gain as first impression might suggest.
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17
Chapter 6
Market Mechanics
OUTLINE
Introduction
Placing Orders
Order Information Flow
Types of Orders
Settlement Procedures
The Specialist and the Book
The Specialist and the Spread
Adjusting Limit and Stop Prices for Dividends
The Ticker Tape
Format
Accuracy
Other Ticker Tape Information
Types of Accounts
Cash Account
Margin Account
Other Types of Accounts
Selling Short
Rationale
Criticisms
Mechanics of a Short Sale
Selling Short Against the Box
Trading Fees
The Costs of Trading
The Commission Structure
Full-Service Brokers
Discount Brokers
Electronic Brokers
Current Events
SUMMARY
A precise protocol should be followed when placing orders with a broker. This protocol helps
eliminate uncertainty about the investor’s exact wishes. The most common types of orders are the
market order, the limit order, and the stop order. Stop orders are especially useful in protecting profits
but can also be used to minimize losses. Unfortunately, investors seldom use them.
The stock exchange specialist helps maintain a fair and orderly market in his or her assigned
securities. These specialists maintain an inventory of shares for sale and are willing to be buyers for
those who wish to sell. If the spread gets too wide, the specialist may enter the market on both sides to
provide better prices for customers.
The ticker tape provides a chronological listing of trades at the exchange. No longer on paper, this
electronic display shows stock symbols, volume, and the price at which trades occurred. On busy days
the tape may run late.
Chapter 6
Market Mechanics
OUTLINE
Introduction
Placing Orders
Order Information Flow
Types of Orders
Settlement Procedures
The Specialist and the Book
The Specialist and the Spread
Adjusting Limit and Stop Prices for Dividends
The Ticker Tape
Format
Accuracy
Other Ticker Tape Information
Types of Accounts
Cash Account
Margin Account
Other Types of Accounts
Selling Short
Rationale
Criticisms
Mechanics of a Short Sale
Selling Short Against the Box
Trading Fees
The Costs of Trading
The Commission Structure
Full-Service Brokers
Discount Brokers
Electronic Brokers
Current Events
SUMMARY
A precise protocol should be followed when placing orders with a broker. This protocol helps
eliminate uncertainty about the investor’s exact wishes. The most common types of orders are the
market order, the limit order, and the stop order. Stop orders are especially useful in protecting profits
but can also be used to minimize losses. Unfortunately, investors seldom use them.
The stock exchange specialist helps maintain a fair and orderly market in his or her assigned
securities. These specialists maintain an inventory of shares for sale and are willing to be buyers for
those who wish to sell. If the spread gets too wide, the specialist may enter the market on both sides to
provide better prices for customers.
The ticker tape provides a chronological listing of trades at the exchange. No longer on paper, this
electronic display shows stock symbols, volume, and the price at which trades occurred. On busy days
the tape may run late.
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Chapter 6: Market Mechanics18
The two main types of accounts are the cash account, in which the investor pays for shares in full,
and the margin account, where a portion of the share cost can be borrowed from the brokerage firm. If
account equity deteriorates too far, the investor may get a margin call under the rules of Federal
Reserve Board Regulation T, requiring the deposit of additional funds or the sale of some security
positions.
Selling short involves the sale of borrowed securities in anticipation of a decline in security prices.
Shares sold short must eventually be covered (bought back). Brokers receive a commission for
executing customer trades. Some firms are full-service firms, providing extensive research and advice.
Others are discount firms, executing orders but providing few other services. Many firms also provide
for making trades via a home computer.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. A market order is to be executed immediately at the best prevailing price. A limit order specifies a
particular price or better as a condition of the trade.
2. A price is touched or passed through. A limit order will remain unfilled if the limit price cannot be
obtained. A stop order is always executed once the stop price is hit.
3. This is not reasonable. With a stop order to sell, the stop price must be below the current market
price.
4. This makes more sense. It either protects a profit or minimizes losses.
5. The broker will not permit this. The stop price of $30 makes no sense, although if it were a limit
order it would be reasonable.
6. This is generally true. With thinly traded stock, a market order may result in an unacceptable price
for some of the shares. Not many shares are likely to be available at the current market price.
7.
GTC Good Till Canceled
GTX Good Till Canceled, eligible for off hours trading
AON All or None
DNR Do Not Reduce
DNI Do Not Increase
NH Not Held
FOK Fill or Kill
OPG Execute at Opening
OC One Cancels the Other
OPEN The trade opens a position
CLOSE The trade closes an existing position
CXL Cancel
8. By entering the market on both sides the specialist bids more or offers to sell for less than any
other market participant. The result of this is that public customers placing market orders pay less
when buying or receive more when selling than if the specialist had not entered the market.
The two main types of accounts are the cash account, in which the investor pays for shares in full,
and the margin account, where a portion of the share cost can be borrowed from the brokerage firm. If
account equity deteriorates too far, the investor may get a margin call under the rules of Federal
Reserve Board Regulation T, requiring the deposit of additional funds or the sale of some security
positions.
Selling short involves the sale of borrowed securities in anticipation of a decline in security prices.
Shares sold short must eventually be covered (bought back). Brokers receive a commission for
executing customer trades. Some firms are full-service firms, providing extensive research and advice.
Others are discount firms, executing orders but providing few other services. Many firms also provide
for making trades via a home computer.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. A market order is to be executed immediately at the best prevailing price. A limit order specifies a
particular price or better as a condition of the trade.
2. A price is touched or passed through. A limit order will remain unfilled if the limit price cannot be
obtained. A stop order is always executed once the stop price is hit.
3. This is not reasonable. With a stop order to sell, the stop price must be below the current market
price.
4. This makes more sense. It either protects a profit or minimizes losses.
5. The broker will not permit this. The stop price of $30 makes no sense, although if it were a limit
order it would be reasonable.
6. This is generally true. With thinly traded stock, a market order may result in an unacceptable price
for some of the shares. Not many shares are likely to be available at the current market price.
7.
GTC Good Till Canceled
GTX Good Till Canceled, eligible for off hours trading
AON All or None
DNR Do Not Reduce
DNI Do Not Increase
NH Not Held
FOK Fill or Kill
OPG Execute at Opening
OC One Cancels the Other
OPEN The trade opens a position
CLOSE The trade closes an existing position
CXL Cancel
8. By entering the market on both sides the specialist bids more or offers to sell for less than any
other market participant. The result of this is that public customers placing market orders pay less
when buying or receive more when selling than if the specialist had not entered the market.
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Chapter 6: Market Mechanics 19
9. An investor places an order with a stockbroker, who transmits it to the exchange, Nasdaq, or the
OTC system. When the order is executed, the buyer must pay for the securities within three
business days of the purchase. (Some of the purchase price may come from the investor’s
brokerage firm if using a margin account.) Sellers have three business days to deliver securities,
receiving payment for them on the third business day after the trade date.
10. When Smith’s order arrived at the specialist’s post, only 300 shares were available at the
prevailing ask price. Because it was a market order, Smith bought 200 more shares at a higher
price.
11. Yes. The limit order specifies a particular price or better. It is possible Smith could pay less than
the limit price for some of the shares.
12. This is a matter of brokerage firm convention. The payment of a dividend causes the share price to
change without any material change in the fortunes of the company. An investor might, for
instance, place a limit order to buy 100 shares at $20 when the stock was selling for $25. If the
firm were to pay an extraordinary $6 cash dividend, the share price would fall below the limit
price and the order would be executed. This is very likely not what the investor would want under
the circumstances.
13. There is no obvious explanation, other than the fact that not reducing the limit price reduces the
likelihood that you will actually make a trade. The limit price will, everything else being equal,
move progressively away from the market. You could argue that this introduces additional
caution in the investment process.
14. Five hundred shares of XYZ stock traded at $34 per share.
15. On days of unusually heavy trading activity, the ticker tape is unable to display the trades in timely
fashion. The tape has a maximum speed, which on a busy day is too slow to keep up with the
pace. The queued trades waiting to come across the screen are “late;” the price reporting system
estimates how long it would take the tape to empty out the queue.
16. She is subject to the $2,000 minimum equity requirement, so she must deposit $2,000 even though
this is more than 50% of the purchase price.
17. Smith’s equity is $56,000 − $23,000 = $33,000. Buying power equals the equity minus the debit
balance, so buying power in this case is $10,000.
18. The minimum portfolio value is the debit balance divided by the quantity one minus the
maintenance margin requirement. In this case, the minimum portfolio value is
$23,000/(1 − .3) = $32,857
19. Upon receipt of a margin call, the investor must deposit cash or securities so as to get the equity
equal to half the portfolio value. With assets worth $78,000 Jones needs $39,000 equity. She has
$23,000, so the required deposit is $16,000.
20. Regulation T serves to limit speculative activity in margin accounts and to ensure that customers
have the financial capacity to repay margin loans.
21. She can withdraw half her buying power in cash, or $6,494.50.
9. An investor places an order with a stockbroker, who transmits it to the exchange, Nasdaq, or the
OTC system. When the order is executed, the buyer must pay for the securities within three
business days of the purchase. (Some of the purchase price may come from the investor’s
brokerage firm if using a margin account.) Sellers have three business days to deliver securities,
receiving payment for them on the third business day after the trade date.
10. When Smith’s order arrived at the specialist’s post, only 300 shares were available at the
prevailing ask price. Because it was a market order, Smith bought 200 more shares at a higher
price.
11. Yes. The limit order specifies a particular price or better. It is possible Smith could pay less than
the limit price for some of the shares.
12. This is a matter of brokerage firm convention. The payment of a dividend causes the share price to
change without any material change in the fortunes of the company. An investor might, for
instance, place a limit order to buy 100 shares at $20 when the stock was selling for $25. If the
firm were to pay an extraordinary $6 cash dividend, the share price would fall below the limit
price and the order would be executed. This is very likely not what the investor would want under
the circumstances.
13. There is no obvious explanation, other than the fact that not reducing the limit price reduces the
likelihood that you will actually make a trade. The limit price will, everything else being equal,
move progressively away from the market. You could argue that this introduces additional
caution in the investment process.
14. Five hundred shares of XYZ stock traded at $34 per share.
15. On days of unusually heavy trading activity, the ticker tape is unable to display the trades in timely
fashion. The tape has a maximum speed, which on a busy day is too slow to keep up with the
pace. The queued trades waiting to come across the screen are “late;” the price reporting system
estimates how long it would take the tape to empty out the queue.
16. She is subject to the $2,000 minimum equity requirement, so she must deposit $2,000 even though
this is more than 50% of the purchase price.
17. Smith’s equity is $56,000 − $23,000 = $33,000. Buying power equals the equity minus the debit
balance, so buying power in this case is $10,000.
18. The minimum portfolio value is the debit balance divided by the quantity one minus the
maintenance margin requirement. In this case, the minimum portfolio value is
$23,000/(1 − .3) = $32,857
19. Upon receipt of a margin call, the investor must deposit cash or securities so as to get the equity
equal to half the portfolio value. With assets worth $78,000 Jones needs $39,000 equity. She has
$23,000, so the required deposit is $16,000.
20. Regulation T serves to limit speculative activity in margin accounts and to ensure that customers
have the financial capacity to repay margin loans.
21. She can withdraw half her buying power in cash, or $6,494.50.
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Chapter 6: Market Mechanics20
22. Selling short against the box is invariably done for tax purposes, specifically to shift a tax liability
into a following tax year.
23. With a limit order on a thinly traded stock there is substantial risk that the order will be filled over
several days. There is a commission on each day in which a trade occurs, so this is likely to be
expensive in terms of trading fees.
24. There is some evidence the spread is wider on Nasdaq securities. Also, some brokerage firms pay
their brokers a larger percentage of the gross commission on Nasdaq trades.
25. The downtick rule supposedly helps stock short selling from “destabilizing” the market when
prices are declining. It is not clear that rising prices are a problem, and, in fact, this is what most
investors want. Permitting purchases on a downtick only would probably inhibit the market rather
than help to stabilize it.
22. Selling short against the box is invariably done for tax purposes, specifically to shift a tax liability
into a following tax year.
23. With a limit order on a thinly traded stock there is substantial risk that the order will be filled over
several days. There is a commission on each day in which a trade occurs, so this is likely to be
expensive in terms of trading fees.
24. There is some evidence the spread is wider on Nasdaq securities. Also, some brokerage firms pay
their brokers a larger percentage of the gross commission on Nasdaq trades.
25. The downtick rule supposedly helps stock short selling from “destabilizing” the market when
prices are declining. It is not clear that rising prices are a problem, and, in fact, this is what most
investors want. Permitting purchases on a downtick only would probably inhibit the market rather
than help to stabilize it.
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21
Chapter 7
Fundamental Stock Analysis
OUTLINE
Introduction
Valuation Philosophies
Investors' Understanding of Risk Premiums
The Time Value of Money
The Importance of Cash Flows
EIC Analysis
Value vs. Growth Investing
The Value Approach to Investing
The Growth Approach to Investing
How Price Is Related to Value
Value Stocks and Growth Stocks: How to Tell by Looking
The Price to Book Ratio
The Price to Earnings Ratio
Differences between Industries
Some Analytical Factors
Growth Rates
The Dividend Discount Model
The Importance of Hitting the Earnings Estimate
The Multistage DDM
Caveats about the DDM
False Growth
A Firm's Cash Flow
Small-Cap, Mid-Cap, and Large-Cap Stocks
Ratio Analysis
DuPont Analysis
Cooking the Books
SUMMARY
Fundamental analysts believe securities are priced according to economic data; technical analysts
believe supply and demand factors are most important. Most investment research deals with predicting
future earnings. A value investor believes a security should be purchased only when the underlying
fundamentals justify the purchase. They believe in a regression to the mean of security returns.
A growth investor seeks rapidly growing companies. Value investors place a great deal of
importance on a stock’s price-to-book ratio and its price-earnings ratio. A future earnings growth rate
is unobservable. Most analysts use several methods to estimate this statistic to determine a likely range
for the value rather than a single number.
The dividend discount model (also called Gordon’s growth model) can be used to value stock as a
growing perpetuity. The shareholders’ required rate of return is an input to the model. False growth in
earnings occurs any time a firm acquires another firm with a lower price-earnings ratio. Cash flow
from operations is a firm’s lifeblood. This value is often used as a check on the quality of a firm’s
earnings.
Ratio analysis can be helpful in determining where a company is weak or strong relative to its
competitors with regard to solvency, efficiency, and profitability. Dun and Bradstreet provides
industry benchmarks that analysts can use in measuring the companies they follow.
Chapter 7
Fundamental Stock Analysis
OUTLINE
Introduction
Valuation Philosophies
Investors' Understanding of Risk Premiums
The Time Value of Money
The Importance of Cash Flows
EIC Analysis
Value vs. Growth Investing
The Value Approach to Investing
The Growth Approach to Investing
How Price Is Related to Value
Value Stocks and Growth Stocks: How to Tell by Looking
The Price to Book Ratio
The Price to Earnings Ratio
Differences between Industries
Some Analytical Factors
Growth Rates
The Dividend Discount Model
The Importance of Hitting the Earnings Estimate
The Multistage DDM
Caveats about the DDM
False Growth
A Firm's Cash Flow
Small-Cap, Mid-Cap, and Large-Cap Stocks
Ratio Analysis
DuPont Analysis
Cooking the Books
SUMMARY
Fundamental analysts believe securities are priced according to economic data; technical analysts
believe supply and demand factors are most important. Most investment research deals with predicting
future earnings. A value investor believes a security should be purchased only when the underlying
fundamentals justify the purchase. They believe in a regression to the mean of security returns.
A growth investor seeks rapidly growing companies. Value investors place a great deal of
importance on a stock’s price-to-book ratio and its price-earnings ratio. A future earnings growth rate
is unobservable. Most analysts use several methods to estimate this statistic to determine a likely range
for the value rather than a single number.
The dividend discount model (also called Gordon’s growth model) can be used to value stock as a
growing perpetuity. The shareholders’ required rate of return is an input to the model. False growth in
earnings occurs any time a firm acquires another firm with a lower price-earnings ratio. Cash flow
from operations is a firm’s lifeblood. This value is often used as a check on the quality of a firm’s
earnings.
Ratio analysis can be helpful in determining where a company is weak or strong relative to its
competitors with regard to solvency, efficiency, and profitability. Dun and Bradstreet provides
industry benchmarks that analysts can use in measuring the companies they follow.
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Chapter 7: Fundamental Stock Analysis22
The evidence shows that small-cap stocks outperform mid- and large-cap stocks. Some analysts
believe that mid-cap stocks are a particularly fertile hunting ground for the security analyst because
they receive less attention from the marketplace. DuPont analysis shows the interplay among
profitability, efficiency, and leverage in determining a firm's return on equity. It helps an investor to
understand what the firm does well and where it may be weak. Spectacular gains are occasionally
associated with initial public offerings (IPOs). These gains usually disappear within the first year or
two of the new stock’s life.
In the next chapter we will look at some of the fundamental analysts' tools in greater detail.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Something only has value because it produces utility. If there is no value, there is no utility.
2. The fundamental analyst believes value comes from rational economic relationships as reflected in
the firm’s financial statements. The technical analyst believes value comes from both rational and
irrational factors, that supply and demand determine price, that changes in supply and demand
cause a change in price, and that changes in supply and demand can be predicted.
3. Earnings are an important measure of the success of a company and, by extension, the success of
an investment. Shareholder return comes both from dividends (that can only be paid from
earnings) and from price appreciation (clearly related to anticipated earnings.)
4. A value investor is willing to wait; he or she seeks “undervalued” companies, those with low PE
ratios and low price/book ratios. The value investor believes in a regression to the mean level of
return, so underperformers are likely to do better and recent stars are likely to perform more
poorly in the future. The growth investor seeks stocks that are currently in favor in the
marketplace, often with a high PE ratio relative to the market average.
5. All fundamental analysts believe in the importance of market information. They agree that new
information can easily move stock prices. The focus of a value investor, however, is not so much
on short-term price movements from news as it is on long-term prospects. A value investor may
make a trade on the basis of new information, but most would not characterize themselves as
information traders.
6. Sixty-years ago the emphasis was on “good companies” rather than “good investments.” Graham
and Dodd said that a stock with good long-term prospects was always a good investment. The
modern viewpoint is that a good company is not necessarily a good investment; the stock price
might be too high.
7. Investors choose stocks based on some set of criteria; value versus growth is one choice someone
might make. For those who invest in mutual funds, the Morningstar categorization permits
selection of an investment portfolio consistent with their preferred style.
8. Book value is an accounting concept that need not have any direct connection to the market price
of the stock. Book value frequently changes solely due to management decisions regarding
obsolescence, depreciation, bad debt write-offs, etc. Sometimes these decisions are immaterial
and largely arbitrary. Such a decision should not affect the price of the stock.
9. Past earnings (a component of a trailing PE) do not matter as much as future earnings. The market
values securities based on anticipated, rather than realized, cash flows.
The evidence shows that small-cap stocks outperform mid- and large-cap stocks. Some analysts
believe that mid-cap stocks are a particularly fertile hunting ground for the security analyst because
they receive less attention from the marketplace. DuPont analysis shows the interplay among
profitability, efficiency, and leverage in determining a firm's return on equity. It helps an investor to
understand what the firm does well and where it may be weak. Spectacular gains are occasionally
associated with initial public offerings (IPOs). These gains usually disappear within the first year or
two of the new stock’s life.
In the next chapter we will look at some of the fundamental analysts' tools in greater detail.
ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS
1. Something only has value because it produces utility. If there is no value, there is no utility.
2. The fundamental analyst believes value comes from rational economic relationships as reflected in
the firm’s financial statements. The technical analyst believes value comes from both rational and
irrational factors, that supply and demand determine price, that changes in supply and demand
cause a change in price, and that changes in supply and demand can be predicted.
3. Earnings are an important measure of the success of a company and, by extension, the success of
an investment. Shareholder return comes both from dividends (that can only be paid from
earnings) and from price appreciation (clearly related to anticipated earnings.)
4. A value investor is willing to wait; he or she seeks “undervalued” companies, those with low PE
ratios and low price/book ratios. The value investor believes in a regression to the mean level of
return, so underperformers are likely to do better and recent stars are likely to perform more
poorly in the future. The growth investor seeks stocks that are currently in favor in the
marketplace, often with a high PE ratio relative to the market average.
5. All fundamental analysts believe in the importance of market information. They agree that new
information can easily move stock prices. The focus of a value investor, however, is not so much
on short-term price movements from news as it is on long-term prospects. A value investor may
make a trade on the basis of new information, but most would not characterize themselves as
information traders.
6. Sixty-years ago the emphasis was on “good companies” rather than “good investments.” Graham
and Dodd said that a stock with good long-term prospects was always a good investment. The
modern viewpoint is that a good company is not necessarily a good investment; the stock price
might be too high.
7. Investors choose stocks based on some set of criteria; value versus growth is one choice someone
might make. For those who invest in mutual funds, the Morningstar categorization permits
selection of an investment portfolio consistent with their preferred style.
8. Book value is an accounting concept that need not have any direct connection to the market price
of the stock. Book value frequently changes solely due to management decisions regarding
obsolescence, depreciation, bad debt write-offs, etc. Sometimes these decisions are immaterial
and largely arbitrary. Such a decision should not affect the price of the stock.
9. Past earnings (a component of a trailing PE) do not matter as much as future earnings. The market
values securities based on anticipated, rather than realized, cash flows.
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Chapter 7: Fundamental Stock Analysis 23
10. This ratio gives some indication of the relationship between the net asset value (equity per share)
of a company and the price the stock currently commands in the marketplace. While this is a
statistic that should be taken with a grain of salt, everything else being equal, a low price to book
ratio is attractive.
11. If you owned 1 share ten years ago (giving you $1.50 in dividends) you would have three today
(giving you $1.80). This is a compound annual growth rate of 1.84%.
12.%2.905.
45$
)05.1)(45($04. =+=k
13. Next period’s dividend yield and the dividend growth rate.
14. Begin with the dividend discount model:P D g
k g0
0 1
= +
−
( )
Take the two partial derivatives:
k
g
D
P
= +1 0
0
k
P
D
P
D g
P0
0
0
2
0
0
2= − −
For all situations except very low stock prices (less than $1 per share), the magnitude of the
growth rate derivative will exceed that of the stock price.
15. There are two assumptions: 1) the long-term dividend growth rate is constant, and 2) the
shareholders’ required rate of return exceeds the dividend growth rate.
16. False growth is the mathematical result causing an increase in earnings per share when a firm
acquires another firm by exchanging shares of stock and the acquirer has a higher PE ratio than the
acquired firm.
17. Cash flow, particularly cash flow from operations, is much less susceptible to manipulation by
managerial decision than net income. Net income may be affected by extraordinary events that are
unrelated to the firm’s primary activity. Good quality earnings will be associated with rising cash
flow from operations. Earnings that are rising in the presence of declining cash flow from
operations are poor quality.
18. See the response to question 17.
19. There is substantial evidence from financial research that small-cap stocks show historically
higher returns than firms with larger capitalization. This is true even on a risk-adjusted basis for
reasons that remain unclear.
10. This ratio gives some indication of the relationship between the net asset value (equity per share)
of a company and the price the stock currently commands in the marketplace. While this is a
statistic that should be taken with a grain of salt, everything else being equal, a low price to book
ratio is attractive.
11. If you owned 1 share ten years ago (giving you $1.50 in dividends) you would have three today
(giving you $1.80). This is a compound annual growth rate of 1.84%.
12.%2.905.
45$
)05.1)(45($04. =+=k
13. Next period’s dividend yield and the dividend growth rate.
14. Begin with the dividend discount model:P D g
k g0
0 1
= +
−
( )
Take the two partial derivatives:
k
g
D
P
= +1 0
0
k
P
D
P
D g
P0
0
0
2
0
0
2= − −
For all situations except very low stock prices (less than $1 per share), the magnitude of the
growth rate derivative will exceed that of the stock price.
15. There are two assumptions: 1) the long-term dividend growth rate is constant, and 2) the
shareholders’ required rate of return exceeds the dividend growth rate.
16. False growth is the mathematical result causing an increase in earnings per share when a firm
acquires another firm by exchanging shares of stock and the acquirer has a higher PE ratio than the
acquired firm.
17. Cash flow, particularly cash flow from operations, is much less susceptible to manipulation by
managerial decision than net income. Net income may be affected by extraordinary events that are
unrelated to the firm’s primary activity. Good quality earnings will be associated with rising cash
flow from operations. Earnings that are rising in the presence of declining cash flow from
operations are poor quality.
18. See the response to question 17.
19. There is substantial evidence from financial research that small-cap stocks show historically
higher returns than firms with larger capitalization. This is true even on a risk-adjusted basis for
reasons that remain unclear.
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