Investment and Portfolio Management

TOPIC 1 – TUTORIAL 1

1. Firms raise capital from investors by issuing shares in the primary markets. Does this imply
that corporate financial managers can ignore trading of previously issued shares in the
secondary market?

Primary market – the market when the company initially offer the shares to the public
Secondary market – the market where the shares are traded after IPO, among investors

The stock market – the secondary market is important to financial managers. As the trading on the
stock price show how the market values the company, whether the company is doing well or not.
The attraction of the company is reflected by the market price and liquidity – the volume of shares
traded in the market. So the more attractive the stock, the easier the company can raise capital.

2. Give an example of three financial intermediaries and explain how they act as a bridge between
small investors and large capital markets or corporations

Mutual funds accept funds from small investors and invest, on behalf of these investors, in the
domestic and international securities markets.
Pension funds accept funds and then invest in a wide range of financial securities, on behalf of
current and future retirees, thereby channeling funds from one sector of the economy to another.
Venture capital firms pool the funds of private investors and invest in start-up firms.
Banks accept deposits from customers and loan those funds to businesses or use the funds to buy
securities of large corporations.

3. The average rate of return on investments in large stocks has outpaced that on investments in
Treasury bills by about 8% since 1926. Why, then, does anyone invest in Treasury bills?

Treasury bills serve a purpose for investors who prefer a low-risk investment. The lower
average rate of return compared to stocks is the price investors pay for predictability of
investment performance and portfolio value.

4. Why are money market securities sometimes referred to as “cash equivalents”?

Money market securities are called cash equivalents because of their high level of liquidity. The
prices of money market securities are very stable, and they can be converted to cash (i.e., sold) on
very short notice and with very low transaction costs. Examples of money market securities include
Treasury bills, commercial paper, and banker's acceptances, each of which is highly marketable
and traded in the secondary market.
 Investment and Portfolio Management

5. A municipal bond carries a coupon of 6.75% and is trading at par. What is the equivalent
taxable yield to a taxpayer in a combined federal plus state 34% tax bracket?

Equivalent taxable yield = Taxable rate / (1 – tax rate) = 6.75% / (1 – 34%) = 10.23%
it is the yield on a taxable bond that an investor would have to earn to match the return on a
comparable tax-free municipal bond.

6. What would you expect to happen to the spread between yields on commercial paper and
Treasury bills if the economy were to enter a steep recession?

Commercial paper is the short-term debt instruments issued by corporation

when the economy enters a steep recession => the default risk of corporation increases => the risk
of the commercial paper will be higher => investors will demand a higher return to hedge the
default risk => the required return (yield) on commercial paper will be higher
T-bills are issued government, usually less than 1 years (short-term) => safer => less affected by
the steep recession => yields are more stable
ð Spread will be widened

7. What are the key differences between common stock, preferred stock, and corporate bonds?

8. Find the after-tax return to a corporation that buys a share of preferred stock at $40, sells it at
year-end at $40, and receives a $4 year-end dividend. The firm is in the 30% tax bracket.
The total before-tax income is $4. After the 70% exclusion for preferred stock dividends,
the taxable income is: 0.30 ´ $4 = $1.20
Therefore, taxes are: 0.30 ´ $1.20 = $0.36
After-tax income is: $4.00 – $0.36 = $3.64
Rate of return is: $3.64/$40.00 = 9.10%
 Investment and Portfolio Management

9.

Look at the listing for General Dynamics.

a. How many shares could you buy for $8,000?
The number of shares = Investment / Price per share = $8000 / 142.97 = 55 shares

b. What would be your annual dividend income from those shares?

Annual dividend income = Dividend per shares x number of shares = $3.04 x 55 = $167.2

c. What must be General Dynamics’ earnings per share?

P/E = Price per share / Earnings per share
ð Earnings per share = Price per share / P/E ratio = $142.97 / 15.39 = $9.3

d. What was the firm’s closing price on the day before the listing?
Net change = -0.47 => the price today is lower than the previous day
ð The firm’s closing price on the day before the listing = $142.97 + $0.47 = $143.44

Extra exercies
 Investment and Portfolio Management

1. What are some advantages and disadvantages of top-down versus bottom-up investing styles?

Top-down investing style:

Asset allocation is the choice among many asset classes (equity, debt, real estate, gold, ...)

Macroeconomic
analysis
Industry
analysis
Stock
analysis

Advantages
Diversification => lower risk
Passive management
ð You do not need to spend more efforts
or resources attempting to improve
portfolio performance through stock
analysis
Disadvantages
Time consuming
Miss the potential high return from the
undervalued securities which aren’t in the
chosen industrial sectors

With a top-down investing style, you focus on asset allocation or the broad composition of the
entire portfolio, which is the major determinant of overall performance. Moreover, top-down
management is the natural way to establish a portfolio with a level of risk consistent with your risk
tolerance. The disadvantage of an exclusive emphasis on top-down issues is that you may forfeit
the potential high returns that could result from identifying and concentrating in undervalued
securities or sectors of the market.
 Investment and Portfolio Management

Bottom-up investing style:

It is an investment approach that focus on the stock analysis

Advantages Disadvantages
High potential returns from undervalued
Maybe not diversified
stocks
Active management
ð Need to spend more efforts and resources to
Less time consuming
improve the portfolio performance
ð More transaction costs
May overlook important macro factors
Depend heavily on the stock valuation model

With a bottom-up investing style, you try to benefit from identifying undervalued securities. The
disadvantage is that investors might tend to overlook the overall composition of your portfolio, which
may result in a non-diversified portfolio or a portfolio with a risk level inconsistent with the appropriate
level of risk tolerance. In addition, this technique tends to require more active management, thus
generating more transaction costs. Finally, the bottom-up analysis may be incorrect, in which case there
will be a fruitlessly expended effort and money attempting to beat a simple buy-and-hold strategy.

2. A firm’s preferred stock often sells at yields below its bonds because
a. Preferred stock generally carries a higher agency rating.
b. Owners of preferred stock have a prior claim on the firm’s earnings.
c. Owners of preferred stock have a prior claim on a firm’s assets in the event of liquidation.
d. Corporations owning stock may exclude from income taxes most of the dividend income
they receive.

3. Short-term municipal bonds currently offer yields of 4%, while comparable taxable bonds pay
5%. Which gives you the higher after-tax yield if your tax bracket is:
a. Zero
=> taxable bond of 5% = after-tax
=> Taxable bond is better

b. 10%
=> after-tax return of 5% taxable bond = 4.5%
=> Taxable bond is better

c. 20%
=> after-tax return of 5% taxable bond = 4%
=> Taxable bond is the same as municipal bond

d. 30%
=> after-tax return of 5% taxable bond = 3.5%
=> Municipal bond is better