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* Chapter

Nineteen

Using

Securities

Markets for

Financing &

Investing

Opportunities

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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*

• With a net worth of $50 billion,

Buffett was the richest person

in the world in 2008.

• Got his big break when he

gained control of Berkshire

Hathaway.

• He invests in undervalued

companies with strong

management.

WARREN BUFFETT Berkshire Hathaway

Profile

19-2

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*

• Securities markets are

financial marketplaces for

stocks and bonds and serve

two primary functions:

1. Assist businesses in finding

long-term funding to finance

capital needs.

2. Provide private investors a place

to buy and sell securities such

as stocks and bonds.

The BASICS of

SECURITIES MARKETS

The Function

of Securities

Markets

LG1

19-3

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*

• Securities markets are divided into primary and

secondary markets:

- Primary markets handle the sale of new securities.

- Secondary markets handle the trading of securities

between investors with the proceeds of the sale going to

the seller.

• Initial Public Offering (IPO) -- The first offering

of a company’s stock.

TYPES of SECURITIES MARKETS The Function

of Securities

Markets

LG1

19-4

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*

• Investment Bankers -- Specialists who assist in the

issue and sale of new

securities.

• Institutional Investors -- Large organizations such as

pension funds or mutual

funds that invest their own

funds or the funds of others.

INVESTMENT BANKERS

and INSTITUTIONAL INVESTORS

The Role of

Investment

Bankers

LG1

19-5

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*

• Stock Exchange -- An organization whose

members can buy and sell securities on behalf of

companies and individual investors.

• Over-the-Counter (OTC) Market -- Provides

companies and investors with a means to trade

stocks not listed on the national securities

exchanges.

• NASDAQ -- A telecommunications network that links

dealers across the nation so they can exchange

securities.

STOCK EXCHANGES Stock

Exchanges

LG2

19-6

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*

• NYSE Euronext

• NASDAQ

• London Stock Exchange

• Tokyo Stock Exchange

• Deutsche Borse

TOP STOCK EXCHANGES Stock

Exchanges

LG2

19-7

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• Securities and Exchange Commission (SEC) -

- The federal agency responsible for regulating the

various stock exchanges; created in 1934 through the

Securities and Exchange Act.

• Prospectus -- A detailed registration statement that

includes extensive economic and financial

information that must be sent to prospective

investors.

The SECURITIES and

EXCHANGE COMMISSION

Securities

Regulations

and the SEC

LG2

19-8

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*

• What’s the primary purpose of a stock exchange?

• Can you name the world’s largest stock

exchange?

• What does NASDAQ stand for? How does this

exchange work?

PROGRESS ASSESSMENT Progress

Assessment

19-9

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*

• After 35 years at Laddie Come Home, you’re

ready to retire as CEO and your compensation

package includes a bonus if the company’s stock

price reaches a certain amount.

• Another company would like to acquire the

company at a price that exceeds the bonus level.

• If you encourage the board to sell the company,

many jobs could be lost. What do you do?

WAGGING the DOG Making Ethical Decisions

19-10

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*

• With apprehensions after the financial crisis of

2008-2009, why would we want to invest in less

familiar global stocks?

• Analysts suggest investing money globally. From

2003-2008, markets in China and Brazil

outperformed the U.S.

• Reviewing suggestions in the text are a good

idea if you want to invest globally.

The WIDE, WIDE

WORLD of INVESTING Reaching Beyond Our Borders

19-11

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• Stocks -- Shares of

ownership in a company.

• Stock Certificate -- Evidence of stock ownership.

• Dividends -- Part of a firm’s

profits that the firm may

distribute to stockholders as

either cash or additional

shares.

LEARNING the

LANGUAGE of STOCKS

Learning the

Language of

Stocks

LG3

19-12

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*

• Stockholders are owners of

a firm and never have to be

repaid their investment.

• There’s no legal obligation to

pay dividends.

• Issuing stock can improve a

firm’s balance sheet since

stock creates no debt.

ADVANTAGES of

ISSUING STOCKS

Advantages &

Disadvantages

of Issuing Stock

LG3

19-13

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• Stockholders have the right to vote for a

company’s board of directors.

• Issuing new shares of stock can alter the control

of the firm.

• Dividends are paid from after-tax profits and are

not tax deductible.

• The need to keep stockholders happy can affect

management’s decisions.

DISADVANTAGES of

ISSUING STOCK

Advantages &

Disadvantages

of Issuing Stock

LG3

19-14

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• Common Stock -- The most basic form; holders

have the right to vote for the board of directors and

share in the profits if dividends are approved.

• Preferred Stock -- Owners are given preference in

the payment of company dividends before common

stock dividends are distributed. Preferred stock can

also be:

- Callable

- Convertible

- Cumulative

TWO CLASSES of STOCK

Issuing Shares

of Common

Stock

LG3

19-15

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*

• Name at least two advantages and

disadvantages of issuing stock as a form of

equity financing.

• What are the major differences between common

stock and preferred stock?

PROGRESS ASSESSMENT Progress

Assessment

19-16

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*

• Bond -- A corporate certificate indicating that an

investor has lent money to a firm.

LEARNING the

LANGUAGE of BONDS

Learning the

Language of

Bonds

LG4

• The principal is the face value

of the bond.

• Interest -- The payment the

bond issuer makes to the

bondholders to compensate them

for the use of their money.

19-17

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*

• Bondholders are creditors, not owners of the

firm and can’t vote on corporate matters.

• Bond interest is tax deductible.

• Bonds are a temporary source of funding and

are eventually repaid.

• Bonds can be repaid before the maturity date if

they contain a call provision.

ADVANTAGES of

ISSUING BONDS

Advantages &

Disadvantages

of Issuing Bonds

LG4

19-18

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*

• Bonds increase debt and can affect the market’s

perception of the firm.

• Paying interest on bonds is a legal obligation.

• If interest isn’t paid, bondholders can take legal

action.

• The face value of the bond must be repaid on

the maturity date.

DISADVANTAGES of

ISSUING BONDS

Advantages &

Disadvantages

of Issuing Bonds

LG4

19-19

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* BOND RATINGS

Advantages &

Disadvantages

of Issuing Bonds

LG4

Rating

Moody’s Standard & Poor’s Description

Aaa AAA Highest Quality

Aa AA High Quality

A A Upper-Medium Grade

Baa BBB Medium Grade

Ba BB Lower-Medium Grade

B B Speculative

Caa CCC, CC Poor

Ca C Highly Speculative

C D Lowest Grade

19-20

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• Corporations can issue two classes of bonds:

1. Unsecured bonds (debenture bonds): not backed

by specific collateral.

DIFFERENT CLASSES of

CORPORATE BONDS

Different

Classes of

Bonds

LG4

2. Secured bonds:

backed by

collateral (land or

equipment).

19-21

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• Sinking Fund -- Reserve account set up to ensure

that enough money will be available to repay

bondholders on the maturity date.

• Callable bonds permit bond issuers to pay off the

principal before the maturity date.

• Convertible bonds allow bondholders to convert

their bonds into shares of common stock.

SPECIAL FEATURES in

BOND ISSUES

Special Bond

Features

LG4

19-22

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• Why are bonds considered a form of debt

financing?

• What does it mean if a firm issues a 9% bond due

in 2025?

• Explain the difference between an unsecured and

secured bond.

• Why are convertible bonds attractive to

investors?

PROGRESS ASSESSMENT Progress

Assessment

19-23

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*

• Stockbroker -- A registered

representative who works as

a market intermediary to buy

and sell securities for clients.

• Online trading services,

such as TD Ameritrade,

E*Trade, and Scottrade,

offer securities trading

services online to buy and

sell stocks and bonds.

BUYING SECURITIES How

Investors

Buy

Securities LG5

19-24

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* PRIMARY INVESTMENT SERVICES

CONSUMERS NEED LG5

• Savings and investing advice

• Help with 401k plans

• Retirement planning

• Tax planning

• Estate planning

• Education expense planning

Source: Investment Company Institute.

Major Services

Consumers Seek

from Financial

Advisers

19-25

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1. Investment risk

2. Yield

3. Duration

4. Liquidity

5. Tax consequences

FIVE INVESTMENT CRITERIA Choosing the

Right

Investment

Strategy LG5

19-26

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* AVERAGE ANNUAL RETURN of

ASSET CLASSES (1926-2007) LG5

Choosing the

Right

Investment

Strategy

Investment Return

Small company stocks 12.2%

Large company stocks 9.5%

Corporate bonds 6.0%

Long-term government bonds 5.8%

Treasury bills 4.1%

Source: Ibbotson Associates and Morningstar. 19-27

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*

• What’s the key advantage of investing through

online brokers? What’s the key disadvantage?

• What’s the primary purpose of diversifying

investments?

PROGRESS ASSESSMENT Progress

Assessment

19-28

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*

• Bulls: Investors who believe stock prices are

going to rise.

PERCEPTIONS of the MARKET Investing in

Stocks

LG6

• Bears: Investors who

expect stock prices to

decline.

19-29

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* BEAR MARKET DECLINES

in the S&P 500 LG6

Time Period % Drop in Prices

2007-2009 52.5%

2000-2002 51%

1973-1974 48.2%

1968-1970 36.1%

1987-1988 33.5%

Investing in

Stocks

Source: Stock Traders Almanac 2009. 19-30

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• Capital Gains -- The positive difference between

the price at which you bought a stock and what you

sell it for.

• Investors can also choose stocks according to

their strategy:

- Blue-chip stocks

- Growth stocks

- Income stocks

- Penny stocks

SELECTING STOCKS Investing in

Stocks

LG6

19-31

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*

• Stock Splits -- An action by a company that gives

stockholders two or more shares of additional stock

for every share that’s outstanding.

• Splits cause no change in the firm’s ownership

structure and no change in the investment’s

value.

• Firms can never be forced to spilt their stocks.

STOCK SPLITS Stock Splits

LG6

19-32

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*

• Buying Stock on Margin -- Borrowing some of the

stock’s purchase cost from the brokerage firm.

BUYING STOCK on MARGIN Buying Stock

on Margin

LG6

• Margin is the portion of the

stock’s purchase price that

the investor must pay with

their own money.

• If a broker issues a margin

call, the investor has to come

up with money to cover

losses. 19-33

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* UNDERSTANDING STOCK

QUOTATIONS

Understanding

Stock

Quotations

LG6

19-34

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* TOP FINANICIAL NEWS and

RESEARCH SITES LG6

• Yahoo Finance

• AOL Money and Finance

• MSN Money

• Forbes

• Dow Jones & Co.

Source: Entrepreneur Magazine, March 2009.

Understanding

Stock

Quotations

19-35

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*

• First-time bond investors generally ask two

questions:

- Do you have to hold a bond until the maturity date?

- How can I assess the investment risk of a particular bond

issue?

• Junk Bonds -- Bonds that have a high risk and

high default rates.

IMPORTANT BOND QUESTIONS Investing in

Bonds

LG7

19-36

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*

• Mutual Fund -- An organization the buys stocks

and bonds and then sells shares in those securities

to the public. The fund pools investors’ money and

buys stocks according to the fund’s purpose.

• Exchange-Traded Fund (ETF) -- Collections of

stocks and bonds that are traded on securities

exchanges but themselves are traded more like

stocks than mutual funds.

INVESTING in MUTUAL FUNDS

and EXCHANGE-TRADED FUNDS LG8

Investing in

Mutual Funds &

Exchange-

Traded Funds

19-37

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* PERCENTAGE of HOUSEHOLDS

OWNING MUTUAL FUNDS LG8

Source: Investment Company Institute.

Investing in

Mutual Funds &

Exchange-

Traded Funds

Year % of Households

1980 5%

1990 24%

2000 43%

2005 42%

2009 44%

19-38

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* THREE VARIETIES of ETFs

LG8

Source: Schwab and E*Trade.

Investing in

Mutual Funds &

Exchange-

Traded Funds

ETF Description

Traditional Most common; include large U.S. stocks,

small U.S. stocks, international stocks, or

investment-grade bonds.

Niche Focus on an individual sector like healthcare,

high-yield bonds, or a single country.

Exotic Invest in unusual, more volatile sectors such

as commodities like gold and concepts like

clean technology.

19-39

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* UNDERSTANDING

MUTUAL FUND QUOTATIONS LG8

Investing in

Mutual Funds &

Exchange-

Traded Funds

19-40

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*

• A number of socially responsible investment

funds (SRIs) are prospering.

INVESTING with INTEGRITY Thinking Green

• SRIs invest only in companies

with exceptional environmental,

social and governance practices.

• SRIs are good investments for

long-term investors - they’re lower

risk than alternative investments.

19-41

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* GROWTH of SOCIALLY

RESPONSIBLE INVESTING LG8

Source: Charles Schwab on Investing.

Investing in

Mutual Funds &

Exchange-

Traded Funds

Year Number of SRIs Total Net Assets

1995 50 $10 Billion

1997 130 $90 Billion

2001 175 $170 Billion

2004 200 $210 Billion

2007 250 $260 Billion

19-42

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* COMPARING INVESTMENTS

LG8

Investing in

Mutual Funds &

Exchange-

Traded Funds

19-43

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*

• What’s a stock split? Why do companies

sometimes split their stock?

• What does buying stock on margin mean?

• What are mutual funds and ETFs?

• What’s the key benefit to investors in investing in

a mutual fund or ETF?

PROGRESS ASSESSMENT Progress

Assessment

19-44

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*

• Dow Jones Industrial Average -- The average

cost of 30 selected industrial stocks.

• Critics say the 30-company Dow is too small a

sample and suggest following the S&P 500.

• S&P 500 tracks the performance of 400

industrial, 40 financial, 40 public utility, and 20

transportation stocks.

KEY STOCK MARKET

INDICATORS

Understanding

Stock Market

Indicators

LG9

19-45

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*

• The stock market has its shares of ups and

downs:

MARKET TURMOIL Investing

Challenges in

the 21st Century

Market

LG9

- October 29, 1929 - Black

Tuesday; the market lost 13%

of its value.

- October 19, 1987 - The market

suffered its worst one-day drop

when it lost 22% of its value.

- October 27, 1997 - Fears of an

economic crisis in Asia cause

widespread panic and losses.

19-46

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*

• The market collapsed into a deep decline in

2000-2002 with the dot-com bubble burst.

- Investors lost $7 trillion in market value.

• In 2008-2009, the collapse of the real estate

market sent financial markets into panic.

- The U.S. government made significant investments in

private banks and offered a large stimulus package to re-

energize the economy.

TURMOIL in the 2000s Investing

Challenges in

the 21st Century

Market

LG9

19-47

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*

• Wall Street - Issued exotic securities; paid excessive

compensation based on bonuses; and investment banks got

the SEC to relax capital requirement.

• Main Street - Americans lived beyond their means;

lenders gave favorable loans to homebuilders; greedy

homeowners took out equity loans; and teaser mortgage

rates let people live large.

• Washington - Gramm-Leach-Billey Act allowed

commercial and investment banks to partner; housing

interest rates were kept low; and Community Reinvestment

Act forced lending to people with bad credit.

WHO’S at FAULT for the

ECONOMIC CRISIS? LG2

Investing

Challenges in

the 21st Century

Market

Source: Fortune Magazine, www.fortune.com. 19-48

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• Fannie Mae bought huge numbers of mortgages

and bundled them into securities they sold.

• Loans were riskier and more complex.

• Borrowers didn’t fully understand and unqualified

borrowers were granted loans they couldn’t

afford.

• As borrowers defaulted on loans, real estate

prices fell. Financial institutions were left with

loans that wouldn’t be repaid.

GAMBLING with INVESTORS’

SECURITY Legal Briefcase *

19-49

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*

• What does the Dow Jones Industrial Average

measure? Why is it important?

• Why do the 30 companies comprising the Dow

change periodically?

• Explain program trading and the problems it can

create.

PROGRESS ASSESSMENT Progress

Assessment

19-50