Practical Investment Management 4th Edition Solution Manual

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1Chapter 1The Concept of InvestingOUTLINEIntroductionInvesting DefinedInvestment AlternativesAssetsSecuritiesSecurity GroupingsThree Reasons for InvestingIncomeAppreciationExcitementThe Academic Study of InvestmentsTheoretical ResearchEmpirical ResearchProfessors vs. PractitionersSUMMARYEven in this short introductory chapter some of the terminology was probably unfamiliar: stocksplits, preferred stock, stop order, buying power, and so on. A substantial vocabulary is specific tothe investment field, and these terms need to become second nature to anyone involved in investingand investment management. Each chapter begins with a list of the KeyTerms covered within thatchapter. A good study technique is to focus on them.The theoretical discussions presented in this book deal generally with fundamental relationshipswe know absolutely. This background—coupled with coverage of market mechanics, folklore, andinstitutional detail—should help to develop an ability to speak intelligently about the investmentbusiness and to influence future financial decisions.ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.Saving is a short or long term activity associated with little chance of loss of principal.Investingis a long-term activity in a risky venture.The risk can be modest or substantialdepending on the characteristics of the investment.2.The SIPC provides investors who have accounts at a brokerage firm with protection againstfailure of the brokerage firm, loss by theft or fire, or fraud of a firm employee.It does notprovide protection against a loss in market value from making poor investments3.A financial asset on one person’s personal balance sheet also appears on someone else’sbalance sheet as a liability.Stocks and bonds are financial assets that appear on the righthand side of the corporate balance sheet. A real asset (such as land or gold) does not have acorresponding liability.

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Chapter 1. The Concept of Investing24.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 notunder the jurisdiction of the Securities and Exchange Commission.There is little practicalimportance to this distinction.)5.Three motivations for investing are to generate income, to realize capital appreciation, andfor 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, sells50 units of currency C for 1 unit of currency B, and sells 1.8 units of currency A for 1 unit ofcurrency C.Assume the spread is zero: buying and selling prices are the same.Inequilibrium, two units of currency A should equal one unit of currency C.Because thedealer sells 1.8 A (instead of 2.0) for each 1.0 C, currency A is overpriced relative tocurrency 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 the10,000 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 assumingthey behave rationally. Mathematical logic then leads to relationships among security pricesthat should hold in a rational world.Empirical researchers look at actual market prices andseek to find statistically significant relationships in the data.Theoretical models are oftentested 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 suchan activity saving rather than investing.

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3Chapter 2Understanding Risk and ReturnOUTLINEIntroductionReturnHolding Period ReturnYield and AppreciationThe Time Value of MoneyFinancial calculatorsCompoundingCompound Annual ReturnRiskRisk vs. UncertaintyDispersion and the Chance of LossThe Problem with LossesRisk AversionPartitioning RiskMore on the Relationship between Risk and ReturnThe Direct RelationshipRisk, Return, and DominanceSUMMARYThe two key concepts in finance are the time value of money and the fact that a safe dollar is worthmore than a risky dollar. The tradeoff between risk and return is the central theme in the investmentdecision-making process. Most investors are risk averse, meaning they only take a risk if they believethey will be rewarded for doing so.A holding period return is independent of the passage of time and should be usedonlyto compareinvestments over identical time periods. The holding period return considers both the yield of aninvestment 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. Theypermit a direct comparison between a particular sum today and amounts in the future. The interest ratethatsatisfiesa time value of moneyequation is a compoundannualreturn. The numberofcompounding 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 timeperiod, the greater the possible dispersion of results. Investment losses are especially consequentialbecause an investment that losesx% must rise by more thanx% just to break even.Virtually all investors are risk averse with significant sums of money. In other words, they will nottake a risk with their money unless they believe the risk is warranted by the potential future returnsfrom the investment.Total risk encompasses the complete variability of investment results. Total risk can be partitionedinto 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 existsbetween expected return and unavoidable risk. Risky investments do not guarantee a return, nor doesunnecessary risk warrant any additional return.

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Chapter 2: Understanding Risk and Return4ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.This statement is generally true, although the concept of risk normally assumes there are certainadverse outcomes involving a chance of loss.2.You cannot comment on the relative performance of competing investments without knowingtheir relative risk. It is also possible that investment B was a $1 million venture, while investmentA was a $250 activity. Dollars are what matter, not percentages.If you have the choice betweenearning 100% on a $250 investment and 20% on a $1 million investment, everyone will prefer thelatter.3.A single large loss requires substantial subsequent gains to overcome the loss. The same is true ofa series of small losses. A key point is that a loss of x% requires a gain of more than x% to breakeven.4.Individual preference.People do not like risk, and since choice 2 appears more risky, the possiblepayoff on choice 2 for 51-100 coming up must be greater than 0 so that the average payoff isgreater than $100. It depends on the individual, however, to make that choice since people alsodiffer in terms of how risk averse they are.5.Increasing the investment horizon increases the potential variability of returns, and hence therange of possible outcomes from the investment. Given that a wider range of values means moreuncertainty about the outcome, from one perspective more time implies more risk.6.See text discussion under "Partitioning Risk."Business RiskVariability of salesFinancial RiskVariability of net earnings from financial leveragePurchasing Power RiskVariability of real return from inflationInterest Rate RiskVariability of return, given changes in market interest ratesForeign Exchange RiskVariability of return caused by varying exchange rates ininvestment periodPolitical RiskVariabilityofreturnrelatedtochangeingovernmentaldecisionsSocial RiskVariabilityofreturnrelatedtochangingconsumerandbusiness reaction to social issues7.Tobacco investments, environmental protection, sweatshop businesses, child labor laws outsidethe U.S.8.Individual preference.9.Individual preference.10.Thereisa greaterdifferencewithannualversus monthlycompounding.Astherate ofcompounding increases the incremental increase in dollars earned decreases.There is a smallerdifference between daily and continuous compounding compared to going from annual to monthlycompounding.

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Chapter 2: Risk and Return511.If interest rates are zero, there is no time value to money. As interest rates increase, present valuesdecrease and future values increase.The higher the interest rate, the greater the “interest oninterest” 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 calculator13$2,940.12 = PV of $4000FV, 4n, 8i14. $2,829.13 = PV of $4000FV, 4.5n, 8i15.$937.50 = PV of $75 payment perpetuity at 8i, 100n, or $75/.0816. $2,876.41 = PV of $500 annuity (pmt), 10n, 8i, or $3355.04 discounted (enter as a FV) for 2n, 8ito present.The first payment of this ordinary annuity, received at the end of the third year, mustbe discounted back two years.17. $7,243.28 = FV of 10n, $500 annuity (pmt), 8i18. $1,469.33 = FV of $1000PV, 5n, 8i19. $1,485.95 = FV of $1000PV, 54 = 20n, 8/4 = 2i20. $1,491.82 = FV of $1000, 5 years, continuous compounding = .08 x 5 =.40 ex$100021.Monthly returns:January 2004-0.0200January 2005-0.0029February 20040.0051February 2005-0.0010March 20040.0051March 20050.0059April 20040.0202April 20050.0078May 20040.0149May 2005-0.0048June 2004-0.0166June 2005-0.0126July 2004-0.0030July 20050.0108August 2004-0.0010August 20050.0049September 2004-0.0090September 20050.0087October 20040.0151October 2005-0.0048November 20040.0010November 20050.0029December 20040.0199December 2005-0.0087Mean (all 24 months) = 0.0016 = 0.16%22. Quarterly ReturnsQ1 2004-0.0100Q1 20050.0020Q2 20040.0182Q2 2005-0.0098Q3 2004-0.0129Q3 20050.0246Q4 20040.0281Q4 2005-0.0106Mean (8 quarters) = 0.0037 = 0.37%23.4.14%24.0.00011425.0.000299

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6Chapter 3The MarketplaceOUTLINEIntroductionThe Role of the Capital MarketsEconomic FunctionContinuous Pricing FunctionFair Pricing FunctionThe ExchangesNational ExchangesRegional ExchangesTrading SystemsCircuit Breakers and Trading CurbsTheNasdaq Stock MarketTheSmall Order Execution System (SOES)The Nasdaq National MarketThe Nasdaq Small-Cap MarketThe Over-The-Counter MarketOver-the-Counter Bulletin Board (OTCBB)Pink Sheet StocksThird and Fourth MarketsRegulationThe ExchangesThe SECThe NASDSIPCEthicsIllegal vs. UnethicalThe Chartered Financial Analyst ProgramThe CFA Program ExamsStandards of Professional ConductSUMMARYThe capital markets serve three primary functions. Theeconomicfunction brings buyers andsellers together. Thecontinuous pricingfunction enables traders to get market prices quickly. Thefair pricingfunction is related to the continuous pricing function and assures both buyers andsellers of getting a market-determined price when they trade.The two national exchanges in the United States are the New York Stock Exchange and theAmerican Stock Exchange.Fiveother 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 electroniclinkup of brokerage firms, brokers and institutional investors place orders by computer. Some verylarge companies areNational Market Issues, with smaller firms listed assmall-capstocks. Theover-the-counter market is distinct from the Nasdaq Stock Market. OTC securities tradeeitherasOTC Bulletin Board stocks or as Pink Sheet issues.

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Chapter 3 The Marketplace7The initial sale of shares occurs in theprimary market. Subsequently, they trade in thesecondary market.The sale of listed securities via the Nasdaq system is called thethird market, while direct institutional tradingvia the Instinet system is thefourth market.Numerousorganizationsregulatethesecuritiesindustry.Themostimportantpiecesoflegislation are the Securities Act of 1933 and the Securities Exchange Act of 1934, whichsignificantly improved the required level of financial disclosure for public securities. The SecuritiesInvestor Protection Corporation provides protection against fraud or brokerage firm failure.The Chartered Financial Analyst (CFA) designation is a prestigious credential for thoseinvolved in the money management business. In many businesses, enrollment in the CFA programis a prerequisite for employment.ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.The continuous pricing function refers to the fact that current prices are routinely determinedand easily accessible through print media or electronically. The fair price function refers to thefact that the substantial number of market participants gives assurance that the prevailing pricefor 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 withoutbarrier from sources to uses.3.The primary market is the sale of securities for the first time, as when Detroit sells newautomobiles to a car dealer.The secondary market is the resale of existing shares, as whenused cars sell through a newspaper classified advertisement.4.The specialist system ensures that all buyers and sellers present their prices at the samelocation. This makes it easy to determine what is the “best” price regardless of the transactionan investor wishes to make.5.You must be a member of an exchange in order to go there and make a trade. Most individualsare 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 theregional exchanges.7.The specialist is charged with making a “fair and orderly market” in his or her assignedsecurities. 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 askprice is the lowest selling price.The spread is the mathematical difference between the bidprice 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 marketmaker system, numerous individuals simultaneously have the opportunity to attempt to get theopposite side of a trade arriving at the exchange.10.The SuperDot system is an electronic trading aid that permits certain trades to be electronicallyrouted to the specialist’s post rather than be hand carried.About 85% of all orders reach thespecialist via this system.

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Chapter 3 The Marketplace811.TheNasdaq stock market is a worldwide, computerized linkup of brokerage firms,investment houses, and large commercial banks for the purpose of trading listed securities.TheOTCmarketreferstothetradingofsecuritiesnotlistedontheNasdaqoranational/regional securities exchange.12. A pink sheet stock is an over-the-counter security about which little information is generallyavailable. They get their name from the long pink sheets of paper that, in years past, wouldhang on a brokerage firm office and show the names of firms that made a market in theshares.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 NewYork Stock Exchange or the American Stock Exchange.The fourth market is directinstitutional trading, usually between large banks, insurance companies, or pension funds.14.The Securities and Exchange Commission seeks to promote “honest and open securitiesmarkets.”It also seeks “full and fair disclosure” of corporate information to potentialinvestors.15.A Ponzi scheme is an illegal activity in which a scam artist accepts “investments” frompeople and later returns part of their principal investment, claiming it is income or otherprofits. 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 theprimary market.The Security Exchange Act of 1934 provides for the regulation of thesecondary market (the trading at the exchanges.)17.The SIPC protects investors against loss due to brokerage firm failure, fraud, theft, or lossdue to natural disaster. It does not provide protection against bad investment decisions.18.TheCFACode of Ethics is a general statement of ethical conduct to which members of theCFA Institutesubscribe.The Standards of Professional Conduct stem directly from theCode of Ethics, but are more detailed statements about dealings with the profession, theemployer, the client, and the investing public.

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9Chapter 4Bond FundamentalsOUTLINEIntroductionBond PrinciplesIdentification of BondsClassification of BondsTerms of RepaymentBond Cash FlowsConvertible and Exchangeable BondsRegistrationThe Financial Page ListingBasic InformationFootnotesGovernment BondsBond Pricing and ReturnsValuation EquationsYield to MaturitySpot RatesRealized Compound YieldCurrent YieldAccrued InterestBond RisksPrice RisksConvenience RisksSUMMARYBonds are identified by their issuer, their coupon, and their maturity year. They are classifiedaccording to the nature of the issuer and according to the security behind them. Some bondsprovide a conversion feature whereby they can be exchanged for another asset-usually shares ofcommon 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 anda single sum to be received in the future. The discount rate that equates the present value of thefuture cash flows with the current price of the bond is the bond’s yield to maturity, which isidentical to the internal rate of return.A major assumption of the yield to maturity calculation is the requirement that coupon proceedsbe reinvested at the bond’s yield to maturity. If the reinvestment rate is different from the bond’srate, the rate of return ultimately realized will be different. By tradition, bond yield to maturity isbased on semiannual compounding.Whencomparingbondswithotherinvestments,theeffectiveannualyield(orrealizedcompound yield) should be used to make a realistic comparison. The yield curve shows therelationship 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 inminimum price increments of1⁄8%, while government bonds trade in 32nds.

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Chapter 4 Bond Fundamentals10Bond risk falls into two major classifications.Price risksrefer to the chance of monetary lossdue to (1) the likelihood of the firm defaulting on its loan payments (default risk), and (2) thevariability of interest rates (interest rate risk).Convenience risksreflectadditional demands onmanagement time because of bonds being called by their issuer, because of the need to reinvestinterest received, or because of poor marketability of a particular issue. Many bonds have a periodof call protection and subsequently a declining call premium.ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.No.Because the cash flows vary through time, they can only be estimated, which means theyield to maturity is also merely an estimate.2.If neither is callable, these securities should sell for the same price.They are equivalentfinancial claims, providing the same income stream from the same issuer, and with the samedegree of risk.3.The statement is generally true. You would like to know, however, details of the call feature, ifany, 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 lifefrom 2-10 years.5.Default risk is the same as credit risk.It is important to an investor, as it measures thelikelihood 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 andmust be replaced with some other security to remain an income producing investment.Thiscan be inconvenient and involve trading fees.7.Accrued interest results in an investor earning one day’s worth of interest for every day he orshe owns the bond.There is no important investment consideration surrounding the interestpayment dates.8.Lowering the bond rating means it has increased default risk.Potential investors will nowrequire 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 tomaturity is typically calculated assuming semi-annual interest payments.When compoundingoccurs more frequently, the realized compound rate will exceed the yield to maturity, and viceversa.10.The coupon payments must be reinvested, and the future reinvestment rate isunobservable.If these payments earn any rate other than the original 14%, the ultimate return to the investorwill be different than 14%.11.Thefive-yearCDpays97.552,1$)209.1(*000,1$10=+.The4.5-yearCDpays40.518,1$)2095.1(*000,1$9=+.The difference in interest paid is $1,552.97−$1,518.40 =$34.57.

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Chapter 4 Bond Fundamentals1112.Solve for P0:Ptt01141440109152100010915250=+++==(.)(.)$941.13.a.This bond will double in price in eight years.Using the Rule of 72, its yield to maturityshould be about 72/8 = 9%.b.50010001216=+()rr = 8.85%14.a.=+++=717)(1$1,000)(1$100$800rrr = 14.77%b.=+++=14114)21(000,1$)21(50$800$ttrrr = 14.67%15.$72.$8.504336066 =per $1,000 par value16.$750$37.()$1,()=+++=50120001214242rrttr = 10.46%$37.(.)$632.5011046275142+==tt84.37%$750$632.75=17.113512114 37%12+−=..18-19Individual response20. There is a difference between 10% simple interest (what Jones is referring to) and a compoundannual 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 bondshe pays accrued interest of (30 + 8)($1.01) = $38.38.On October 1 he receives an interestcheck for (0.0725/2)($5,000) = $181.25. When he sells the bonds, he receives accrued interestof (30)($1.01) = $30.30.interest check received$181.25accrued interest received$30.30minus accrued interest paid−$38.18Total$173.17

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Chapter 4 Bond Fundamentals1222a.It is important to recognize that the concept of “portfolio yield to maturity” is fuzzy whenthe securities in a portfolio do not have a common maturity. Still, it is possible to calculate theportfolio internal rate of return, which is what must be done in this circumstance.Assumingannual coupons for simplicity, the valuation equation looks as follows.$2,$100$110()$100$1,()$100()$1,()0001100111001234=+++++++++rrrrSolving for r, we get 10.19%.b. If the securities have a common maturity, the portfolio yield to maturity will be close to theaverage 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 issuerfor 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 purchaseprice 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 lessthan 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. Asthe bond’s maturity date approaches, the bond price will approach par, which in this casemeans it will decline.30. a. It is difficult to compare the reinvestment rate risk without knowing the bond coupons. Allelse being equal, the higher priced bond would have the higher coupon, so it would be the bestguess.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 relativeinterest rate risk of these two bonds. The bond selling for the greatest deviation from par valueis likely to have the greatest price volatility, everything else being equal.The 70% bondprobably has the most interest rate risk.31. (CFA Guideline Answers; reprinted with permission).A.A sinking fund is a provision that calls for themandatoryearly redemption of a bond issue.The provision may be for a specific number of bonds or a percentage of bonds over a specifiedtime horizon. The sinking fund can retire all or a portion of an issue over its life.

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Chapter 4 Bond Fundamentals13B.(i) Compared to a bond without a sinking fund, the sinking fund will reduce the averagematurity 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 associatedwith 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 theprincipal 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 pricevolatility of the issue.Downside protection is further provided by the existence of a forcedbuyer (the issuer for sinking fund requirements) regardless of market conditions.D.The call protection provision is absolute protection for an investor, preventing the companyfrom redeeming an issue short of the call date or maturity date.Refunding protection is lessrestrictive. With refunding protection, the company is prohibited from redeeming an issue withlower cost debt ranking equally or superior to the debt being redeemed.The issue can still becalled using other sources of funds such as retained earnings common stock, or sale ofproperty.Several recent cases illustratethe general ineffectiveness of refunding protection inthe real world.32. First solve for the yield to maturity of the step-down bond by solving the following equation.15142)1(25.107)1(25.7150.85.99rrrtt+++++==r = 7.44%Then solve for P0in this equation:151420)0744.1(50.108)0744.1(50.80744.125.7P+++++==tt= 108.23 or $1,082.30

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14Chapter 5Common StockOUTLINEIntroductionCorporations, Shares, and Shareholder RightsCorporationsSharesShareholder RightsThe Mystique of DividendsTypes of DividendsSpecial DistributionsThe Dividend Payment ProcedureWhy Dividends Do Not MatterStock SplitsForward and Reverse SplitsWhy Stock Splits Do Not MatterWhy Firms Split Their StockStock Splits vs. Stock DividendsThe Financial Page ListingThe Basic InformationFootnotes and SymbolsCategories of StockBlue Chip StocksIncome StocksCyclical StocksDefensive StocksGrowth StocksSpeculative StocksPenny StocksCategory OverlapA Note on Stock SymbolsSUMMARYDividends are an important part of the investment business, but not because they instantly increasean investor’s wealth. Dividends do not grow on trees; they come from the issuer’s checking accountand reduce the value of the firm when they are paid. Dividends do provide current income, but they doso at the expense of future growth.A precise chronology of events surrounds the payment of a dividend. The ex-dividend dateconvention eliminates uncertainty regarding entitlement to forthcoming dividends.Stock splits, like dividends, also do not alter the collective wealth of the shareholders. They areanalogous to cutting pieces of a pie into smaller slices. The total quantity of pie does not change as theserving 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 arethey precise.

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Chapter 5: Common Stock15ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.A stock dividend merely increases the number of outstanding shares of stock.It does nothing toincrease the assets or equity of the firm.After payment of the stock dividend, the shareholderholds more shares, but they are worth proportionately less.2.There are issuance costs such as clerical time, postage, and the printing of stock certificatesassociated with paying a stock dividend.Because a stock dividend does not increase theshareholders’wealth,itseemseconomicallyunsoundtopaysucha 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 bothresult in a reduced share price.One difference, however, lies in the fact that the market value ofcash is clear; the market value of the distributed property is less clear.As a consequence, thestock 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 theshareholders.Firms do not raise dividends unless they believe the increased dividend can besustained. 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 andvisually inspect the relationship.Even better, perhaps, would be a comparison of GT with somemeasure of the economy such as Gross Domestic Product.With a cyclical stock, you wouldexpect to see the stock performance follow the overall economy.6.If the financial trouble was unanticipated, the stock price would likely decline because of theadverse 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 stockprice constant or even bidding it up.7.Investors like a predictable dividend pattern. Also, a managerial decision to reduce dividends is anadverse signal that is likely to reduce share value.Management wants to act in such a way as tomaximize 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 onTV (allow the rights to expire unexercised.)9. The board of directors wants to maximize shareholderwealth. This is not the same as maximizingthe stock price.Investors would prefer to have two shares worth $30 each rather than a singleshare worth $50. You can say that the firm wants to maximize share value, but only if you add thecaveat that the number of shares remains constant.

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Chapter 5. Common Stock1610.DateEventNew SharesTotal Sharesbeginning of 19751,000197610% stock dividend1001,100197710% stock dividend1101,21019785 for 4 stock split302*1,5121979100% stock dividend1,5123,02419842-for-1 stock split3,0246,04819954-for-1 stock split18,14424,192* Plus 0.5 shares in cash11. Student response.12.GEGeneral Electric (NYSE)AERTAAdvanced Environmental RecyclingTechnologies Inc.(Nasdaq)TGITriumph Group,Inc. (NYSE)MWDNot A Valid Ticker SymbolNATRNature’s Sunshine Products (Nasdaq)A good Internet symbol database is athttp://www.stockcenter.com/symlook/symlook.htm.13. Because the shareholders collectively own the company, it seems that no distribution, even one inerror, should increase their wealth.In fact, given that this was a screw-up with associatedadministrative costs, it may very well have reduced shareholder wealth across the board. Certainlyit should not have been a windfall gain as first impression might suggest.

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17Chapter 6Market MechanicsOUTLINEIntroductionPlacing OrdersOrder Information FlowTypes of OrdersSettlement ProceduresThe Specialist and theBookThe Specialist and the SpreadAdjusting Limit and Stop Prices for DividendsThe Ticker TapeFormatAccuracyOther Ticker Tape InformationTypes of AccountsCash AccountMargin AccountOther Types of AccountsSelling ShortRationaleCriticismsMechanics of a Short SaleSelling Short Against the BoxTrading FeesThe Costs of TradingThe Commission StructureFull-Service BrokersDiscount BrokersElectronic BrokersCurrent EventsSUMMARYAprecise protocol should be followed when placing orders with a broker.This protocol helpseliminate uncertainty about the investor’s exact wishes. The most common types of orders are themarket order, the limit order, and the stop order. Stop orders are especially useful in protecting profitsbut 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 assignedsecurities. These specialistsmaintain an inventory of shares for sale and are willing to be buyers forthose who wish to sell. If the spread gets too wide, the specialist may enter the market on both sides toprovide better prices for customers.The ticker tape provides a chronological listing of trades at the exchange. No longer on paper, thiselectronic display shows stock symbols, volume, and the price at which trades occurred. On busy daysthe tape may run late.

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Chapter 6: Market Mechanics18The 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. Ifaccount equity deteriorates too far, the investor may get a margin call under the rules of FederalReserve Board Regulation T, requiring the deposit of additional funds or the sale of some securitypositions.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 forexecuting 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 providefor making trades via a home computer.ANSWERS TO END OF CHAPTER QUESTIONS AND PROBLEMS1.A market order is to be executed immediately at the best prevailing price. A limit order specifies aparticular price or better as a condition of the trade.2.A price is touched or passed through. A limit order willremain unfilledif the limit price cannot beobtained. 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 marketprice.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 limitorder it would be reasonable.6. This is generally true. With thinly traded stock, a market order may result in an unacceptable pricefor some of the shares. Not many shares are likely to be available at the current market price.7.GTCGood Till CanceledGTXGood Till Canceled, eligible for off hours tradingAONAll or NoneDNRDo Not ReduceDNIDo Not IncreaseNHNot HeldFOKFill or KillOPGExecute at OpeningOCOne Cancels the OtherOPENThe trade opens a positionCLOSEThe trade closes an existing positionCXLCancel8.By entering the market on both sides the specialist bids more or offers to sell for less than anyother market participant. The result of this is that public customers placing market orders pay lesswhen buying or receive more when sellingthan if the specialist had not entered the market.

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Chapter 6: Market Mechanics199.An investor places an order with a stockbroker, who transmits it to the exchange, Nasdaq, or theOTC system.When the order is executed, the buyer must pay for the securities within threebusiness days of the purchase.(Some of the purchase price may come from the investor’sbrokerage 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 theprevailing ask price.Because it was a market order, Smith bought 200 more shares at a higherprice.11. Yes. The limit order specifies a particular priceor better. It is possible Smith could pay less thanthe 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 tochange without any material change in the fortunes of the company.An investor might, forinstance, place a limit order to buy 100 shares at $20 when the stock was selling for $25.If thefirm were to pay an extraordinary $6 cash dividend, the share price would fall below the limitprice and the order would be executed. This is very likely not what the investor would want underthe circumstances.13. There is no obvious explanation, other than the fact that not reducing the limit price reduces thelikelihood 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 additionalcaution 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 timelyfashion.The tape has a maximum speed, which on a busy day is too slow to keep up with thepace.The queued trades waiting to come across the screen are “late;” the price reporting systemestimates 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 thoughthis 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 debitbalance, so buying power in this case is $10,000.18.The minimum portfolio value is the debit balance divided by the quantity one minus themaintenance margin requirement. In this case, the minimum portfolio value is$23,000/(1−.3) = $32,85719. Upon receipt of a margin call, the investor must deposit cash or securities so as to get the equityequal 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 andto ensure that customershave 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 Mechanics2022. Selling short against the box is invariably done for tax purposes, specifically to shift a tax liabilityinto a following tax year.23. With a limit order on a thinly traded stock there is substantial risk that the order will be filled overseveral days.There is a commission on each day in which a trade occurs, so this is likely to beexpensive in terms of trading fees.24. There is some evidence the spread is wider on Nasdaq securities. Also, some brokerage firms paytheir brokers a larger percentage of the gross commission on Nasdaq trades.25. The downtick rule supposedly helps stock short selling from “destabilizing” the market whenprices are declining. It is not clear that rising prices are a problem, and, in fact, this is what mostinvestors want. Permitting purchases on a downtick only would probably inhibit the market ratherthan help to stabilize it.

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21Chapter 7Fundamental Stock AnalysisOUTLINEIntroductionValuation PhilosophiesInvestors' Understanding of Risk PremiumsThe Time Value of MoneyThe Importance of Cash FlowsEIC AnalysisValue vs. Growth InvestingThe Value Approach to InvestingThe Growth Approach to InvestingHow PriceIsRelatedto ValueValue Stocks and Growth Stocks: How to Tell by LookingThe Price to Book RatioThe Price to Earnings RatioDifferences between IndustriesSome Analytical FactorsGrowth RatesThe Dividend Discount ModelThe Importance of Hitting the EarningsEstimateThe Multistage DDMCaveats about the DDMFalse GrowthA Firm's Cash FlowSmall-Cap, Mid-Cap, and Large-Cap StocksRatio AnalysisDuPont AnalysisCooking the BooksSUMMARYFundamental analysts believe securities are priced according to economic data; technical analystsbelieve supply and demand factors are most important. Most investment research deals with predictingfuture earnings. A value investor believes a security should be purchasedonlywhen the underlyingfundamentals 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 ofimportance on a stock’s price-to-book ratio and its price-earnings ratio. A future earnings growth rateis unobservable. Most analysts use several methods to estimate this statistic to determine a likely rangefor the value rather than a single number.The dividend discount model (also called Gordon’s growth model) can be used to value stock as agrowing perpetuity. The shareholders’ required rate of return is an input to the model. False growth inearnings occurs any time a firm acquires another firm with a lower price-earnings ratio. Cash flowfrom operations is a firm’s lifeblood. This value is often used as a check on the quality of a firm’searnings.Ratio analysis can be helpful in determining where a company is weak or strong relative to itscompetitors with regard to solvency, efficiency, and profitability. Dun and Bradstreet providesindustry benchmarks that analysts can use in measuring the companies they follow.

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Chapter 7: Fundamental Stock Analysis22The evidence shows that small-cap stocks outperform mid-andlarge-cap stocks. Some analystsbelieve that mid-cap stocks are a particularly fertile hunting ground for the security analyst becausethey receive less attention from the marketplace.DuPont analysis shows the interplay amongprofitability, efficiency, and leverage in determining a firm's return on equity. It helps an investor tounderstand what the firm does well and where it may be weak.Spectacular gains are occasionallyassociated with initial public offerings (IPOs). These gains usually disappear within the first year ortwo 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 PROBLEMS1.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 inthe firm’s financial statements. The technical analyst believes value comes from both rational andirrational factors, that supply and demand determine price, that changes in supply and demandcause 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 ofan investment.Shareholder return comes both from dividends (that can only be paid fromearnings) 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 PEratios and low price/book ratios.The value investor believes in a regression to the mean level ofreturn, so underperformers are likely to do better and recent stars are likely to perform morepoorly in the future.The growth investor seeks stocks that are currently in favor in themarketplace, 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 newinformation can easily move stock prices. The focus of a value investor, however, is not so muchon short-term price movements from news as it is on long-term prospects.A value investor maymake a trade on the basis of new information, but most would not characterize themselves asinformation traders.6.Sixty-years ago the emphasis was on “good companies” rather than “good investments.” Grahamand Dodd said that a stock with good long-term prospects was always a good investment.Themodern viewpoint is that a good company is not necessarily a good investment; the stock pricemight be too high.7.Investors choose stocks based on some set of criteria; value versus growth is one choice someonemight make.For those who invest in mutual funds, the Morningstar categorization permitsselection 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 priceof the stock.Book value frequently changes solely due to management decisions regardingobsolescence, depreciation, bad debt write-offs, etc.Sometimes these decisions are immaterialand 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 marketvalues securities based on anticipated, rather than realized, cash flows.

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Chapter 7: Fundamental Stock Analysis2310. 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 astatistic that should be taken with a grain of salt, everything else being equal, a low price to bookratio 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.=+=k13.Next period’s dividend yield and the dividend growth rate.14.Begin with the dividend discount model:PDgkg001=+−()Take the two partial derivatives:kgDP=+100kPDPD gP0002002= −−For all situations except very low stock prices (less than $1 per share), the magnitude of thegrowth 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) theshareholders’ 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 firmacquires another firm by exchanging shares of stock and the acquirer has a higher PE ratio than theacquired firm.17.Cash flow, particularly cash flow from operations, is much less susceptible to manipulation bymanagerial decision than net income. Net income may be affected by extraordinary events that areunrelated to the firm’s primary activity. Good quality earnings will be associated with rising cashflow from operations.Earnings that are rising in the presence of declining cash flow fromoperations are poor quality.18.See the response to question 17.19.There is substantial evidence from financial research that small-cap stocks show historicallyhigher returns than firms with larger capitalization.This is true even on a risk-adjusted basis forreasons that remain unclear.

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