Chapter 9

1. Chapter 9 Investing in Business: Stocks and Bonds A bargain that is going to become a greater bargain is no bargain. MARTIN SHUBIK

2. Figure 1 NASDAQ Stock Market Composite Index, 1990–2007

3. Corporations & Unique Characteristics • Corporation • Firm - legal status of a fictional individual • Owned by - stockholders • Run by • Set of elected officers • Board of directors • Chairman

4. Corporations & Unique Characteristics • Special privileges & special obligations • Special limits on losses • Stockholders: Limited liability • Legal obligation • Firm’s owners – pay back company debts • Money already invested in firm • Double taxation • Company’s earnings • Dividends – personal income tax • Corporation – entity • Distinct from: owners or management

5. Corporations & Unique Characteristics • Common stock / share - of a corporation • Piece of paper • Stock holder • Partial ownership • Bond - IOU sold by corporation • Promise: pay the holder • A fixed sum of money - specified maturity date • Some other fixed amount of money • Coupon / interest payment • Every year - up to maturity date

6. Corporations & Unique Characteristics • Differences between stocks and bonds • Ownership • Stock – ownership & some control • Bond – lends money; no ownership • Money received back • Stock – no idea: value when sold & dividends • Bond – high degree of certainty • Prior claim on company earnings • Bonds – yes; Stocks – no • Bonds - less risky than stocks

7. Corporations & Unique Characteristics • Similarities between stocks and bonds • Ownership - few shares • Control - more symbolic than real • Stockholders – riskier loans • Bonds - can be very risky • Sell before maturity • Losses from inflation • Firm - issue bonds with little backing • “Junk bonds”

8. Corporations & Unique Characteristics • Inflation • Rapid rise in prices • Rate of inflation • Average • Percentage growth rate • Prices of selected sample of commodities

9. Corporations & Unique Characteristics • Interest rate • Amount • Borrowers - pay to lenders • Per dollar of money borrowed • Current market price of a loan • Interest rates – rise • Prices of previously issued bonds - fall • With lower interest earnings • Interest rates – fall • Prices of previously issued bonds – rise

10. Corporations & Unique Characteristics • Corporate choice: Stocks or Bonds • Bonds – riskier for firms • Commitment – fixed annual payment • Buyers of securities • Stocks – riskier • Stockholders – expect to be paid more • Than bondholders

11. Corporations & Unique Characteristics • Plowback / retained earnings • Portion of corporation’s profits • Reinvested • Not paid as dividends • Lower risk • Easier than issuing new stocks or bonds

12. Figure 2 Sources of new funds for U.S. corporations, 2005

13. Corporations & Unique Characteristics • Determinants of stock price • Behavior of supply and demand • Sellers and buyers • Firm’s earnings • Stock market • Good investment in long run • Very risky – shorter periods

14. Buying Stocks and Bonds • Brokerage firms • Bargain brokerage houses • Low cost; very little service • Higher-service brokerage firms • Higher cost; higher service • Internet • Low/no cost • Market order purchase • Limit order

15. Buying Stocks and Bonds • First rule of safe investing • Always diversify • Portfolio of investments • Person / organization’s securities holdings • Several different corporations • Portfolio diversification • Individual’s portfolio • Number & variety • Stocks, Bonds, Other

16. Buying Stocks and Bonds • Mutual fund • Individual investors can buy shares • Private investment firm • Holds a portfolio of securities • Index fund - Mutualfund • Chooses a particular stock price index • Buys stocks (or most of the stocks) in index • Stock price index • Average: prices of a large set of stocks

17. Buying Stocks and Bonds • Stock market information • Company name • Stock’s highest & lowest prices - last year • Annual dividend per share • Yield • Dividend as a percentage of closing price • P/E ratio - price-to-earnings ratio • Price per share divided by • Company’s net earnings per share • Previous year

18. Buying Stocks and Bonds • Stock market information • Number of shares traded • Previous day • Yesterday’s • Highest & lowest price • Closing price - price of last transaction • Change in price from previous day

19. Figure 3 Excerpt from a stock price table

20. Buying Stocks and Bonds • Bond market information • Company name • Maturity date • Coupon – annual interest payment • Current yield • Coupon divided by price • Yesterday’s • Trading volume • Closing price • Change in price from previous day

21. Figure 4 Excerpt from a bond price table

22. Stock Exchanges & Their Functions • New York Stock Exchange (NYSE) • “The Big Board” • World’s most prestigious stock market • Best-known & most heavily traded securities • Little over half - all stock market transactions - United States ($ volume)

23. Stock Exchanges & Their Functions • Regional Stock Exchanges • Chicago, Pacific, Philadelphia, • Boston, Cincinnati • Many of the stocks handled on NYSE • Serve large institutional customers • Banks, insurance companies, mutual funds • American Stock Exchange • American & Regional Stock Exchanges • Less than 10% of total stock traded

24. Stock Exchanges & Their Functions • NASDAQ / Nasdaq Stock Market • National Association of Securities Dealers • Most of the “tech” stocks • No physical trading floor • Transactions - computer network • Stocks of approximately 3,300 companies

25. Stock Exchanges & Their Functions • Home computers – internet • Number of online trading accounts • Major U.S. brokerages • 1.5 million in 1997 • 19.7 million - end of 2001 • 50 million in 2004

26. Stock Exchanges & Their Functions • Regulation of stock market • Government • Securities and Exchange Commission (SEC) • Industry • Stock brokerage firms • NYSE, American Stock Exchange, NASDAQ, • Regional exchanges

27. Stock Exchanges & Their Functions • New stock issues • Handled by investment bank • Stock markets • Trade “secondhand securities” • Stock exchanges’ functions • Secondhand market for stocks • Individual investment - less risky • Easier for corporations to issue new stocks • Determines current price of company’s stocks

28. Stock Exchanges & Their Functions • Firm - promising future • Stock - high price on stock exchanges • Increased ability to raise capital • Stock market • Allocate economy’s resources • To firms - best use resources

29. Stock Exchanges & Their Functions • Takeover • Outside group (raiders) • Acquisition - controlling proportion of company’s stock • Hostile takeover • Takeover • Old management – opposes takeover

30. Speculation • Speculation • Deliberate investment in risky assets • Hope: obtain profits • Future changes in assets’ prices • Speculators - vital economic functions • Sell protection from risk to other people • Help smooth out price fluctuations • Buy – when abundant & cheap • Resell – when scarce & expensive

31. Speculation • Stock prices • Approximate a random walk • Time path of a variable - random walk • Magnitude in one period • = value in preceding period • + completely random number • Random number • Positive or negative