*

Chapter
Nineteen

*
Using
Securities
Markets for
Financing &
Investing
Opportunities

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

Berkshire Hathaway
*
• 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.
19-2
 *The Function
The BASICS of of Securities
Markets
SECURITIES MARKETS LG1
*
• 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.
19-3
 *The Function
TYPES of SECURITIES MARKETS of Securities
Markets
LG1
*
• 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.

19-4
 *The Role of
INVESTMENT BANKERS Investment
Bankers
and INSTITUTIONAL INVESTORS LG1
*
• 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.
19-5
 *Stock
STOCK EXCHANGES Exchanges

LG2
*
• 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.
19-6
 *Stock
TOP STOCK EXCHANGES Exchanges

LG2
*
• NYSE Euronext

• NASDAQ

• London Stock Exchange

• Tokyo Stock Exchange

• Deutsche Borse

19-7
 *Securities
The SECURITIES and Regulations
and the SEC
EXCHANGE COMMISSION LG2
*
• 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.

19-8
 * Progress
PROGRESS ASSESSMENT Assessment

*
• 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?

19-9
 *
WAGGING the DOG
Making Ethical Decisions
*
• 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?
19-10
 *
The WIDE, WIDE
WORLD of INVESTING
Reaching Beyond Our Borders *
• 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.
19-11
 * Learning the
LEARNING the Language of
Stocks
LANGUAGE of STOCKS LG3
*
• 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.
19-12
 *
Advantages &
ADVANTAGES of Disadvantages
of Issuing Stock
ISSUING STOCKS LG3
*
• 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.
19-13
 *
Advantages &
DISADVANTAGES of Disadvantages
of Issuing Stock
ISSUING STOCK LG3
*
• 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.
19-14
 * Issuing Shares
of Common
TWO CLASSES of STOCK Stock

LG3
*
• 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
19-15
 * Progress
PROGRESS ASSESSMENT Assessment

*
• 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?

19-16
 *Learning the
LEARNING the Language of
Bonds
LANGUAGE of BONDS LG4
*
• Bond -- A corporate certificate indicating that an
investor has lent money to a firm.

• 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
 *Advantages &
ADVANTAGES of Disadvantages
of Issuing Bonds
ISSUING BONDS LG4
*
• 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.
19-18
 * Advantages &
DISADVANTAGES of Disadvantages
of Issuing Bonds
ISSUING BONDS LG4
*
• 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.
19-19
 * Advantages &
BOND RATINGS 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
 *Different
DIFFERENT CLASSES of Classes of
Bonds
CORPORATE BONDS LG4
*
• Corporations can issue two classes of bonds:
1. Unsecured bonds (debenture bonds): not backed
by specific collateral.
2. Secured bonds:
backed by
collateral (land or
equipment).

19-21
 *Special Bond
SPECIAL FEATURES in Features

BOND ISSUES LG4

*
• 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.

19-22
 * Progress
PROGRESS ASSESSMENT Assessment

*
• 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?
19-23
 *How
BUYING SECURITIES Investors Buy
Securities
LG5
*
• 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.
19-24
 *
Major Services
PRIMARY INVESTMENT SERVICES Consumers Seek
from Financial
CONSUMERS NEED Advisers
LG5
*
• Savings and investing advice
• Help with 401k plans
• Retirement planning
• Tax planning
• Estate planning
• Education expense planning

Source: Investment Company Institute.

19-25
 *
Choosing the
FIVE INVESTMENT CRITERIA Right
Investment
Strategy
LG5
*
1. Investment risk

2. Yield

3. Duration

4. Liquidity

5. Tax consequences

19-26
 * Choosing the
AVERAGE ANNUAL RETURN of Right
Investment
ASSET CLASSES (1926-2007) Strategy
LG5
*
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
 * Progress
PROGRESS ASSESSMENT Assessment

*
• What’s the key advantage of investing through
online brokers? What’s the key disadvantage?

• What’s the primary purpose of diversifying

investments?

19-28
 *Investing in
PERCEPTIONS of the MARKET Stocks

LG6
*
• Bulls: Investors who believe stock prices are
going to rise.

• Bears: Investors who

expect stock prices to
decline.

19-29
 *Investing in
BEAR MARKET DECLINES Stocks
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%

Source: Stock Traders Almanac 2009.

19-30
 *Investing in
SELECTING STOCKS Stocks

LG6
*
• 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

19-31
 *
STOCK SPLITS Stock Splits

LG6
*
• 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.

19-32
 *
BUYING STOCK on MARGIN Buying Stock
on Margin

LG6
*
• Buying Stock on Margin -- Borrowing some of the
stock’s purchase cost from the brokerage firm.

• 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
 *Understanding
UNDERSTANDING STOCK Stock
Quotations
QUOTATIONS LG6
*

19-34
 *Understanding
TOP FINANICIAL NEWS and Stock
RESEARCH SITES Quotations
LG6
*
• Yahoo Finance
• AOL Money and Finance
• MSN Money
• Forbes
• Dow Jones & Co.

Source: Entrepreneur Magazine, March 2009.

19-35
 *Investing in
IMPORTANT BOND QUESTIONS Bonds

LG7
*
• 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.

19-36
 * Investing in

INVESTING in MUTUAL FUNDS Mutual Funds &

Exchange-

and EXCHANGE-TRADED FUNDS Traded Funds

LG8
*
• 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.

19-37
 * Investing in
PERCENTAGE of HOUSEHOLDS Mutual Funds &
Exchange-
OWNING MUTUAL FUNDS Traded Funds
LG8
*
Year % of Households
1980 5%
1990 24%
2000 43%
2005 42%
2009 44%

Source: Investment Company Institute.

19-38
 * Investing in
Mutual Funds &
THREE VARIETIES of ETFs Exchange-
Traded Funds
LG8
*
ETF Description

Most common; include large U.S. stocks,

Traditional small U.S. stocks, international stocks, or
investment-grade bonds.

Focus on an individual sector like healthcare,

Niche high-yield bonds, or a single country.

Invest in unusual, more volatile sectors such

Exotic as commodities like gold and concepts like
clean technology.

Source: Schwab and E*Trade.

19-39
 * Investing in

UNDERSTANDING Mutual Funds &

Exchange-

MUTUAL FUND QUOTATIONS Traded Funds

LG8
*

19-40
 *
INVESTING with INTEGRITY
Thinking Green
*
• A number of socially responsible investment
funds (SRIs) are prospering.
• 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
 * Investing in
GROWTH of SOCIALLY Mutual Funds &
Exchange-
RESPONSIBLE INVESTING Traded Funds
LG8
*
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

Source: Charles Schwab on Investing.

19-42
 * Investing in

COMPARING INVESTMENTS
Mutual Funds &
Exchange-
Traded Funds
LG8
*

19-43
 * Progress
PROGRESS ASSESSMENT Assessment

*
• 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?

19-44
 * Understanding
KEY STOCK MARKET Stock Market
Indicators
INDICATORS LG9
*
• 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.

19-45
 * Investing

MARKET TURMOIL
Challenges in
the 21st Century
Market
LG9
*
• The stock market has its shares of ups and
downs:
- 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
 * Investing

TURMOIL in the 2000s

Challenges in
the 21st Century
Market
LG9
*
• 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.

19-47
 * Investing

WHO’S at FAULT for the Challenges in

the 21st Century

ECONOMIC CRISIS? Market

LG2
*
• 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.
Source: Fortune Magazine, www.fortune.com.
19-48
 *
GAMBLING with INVESTORS’
SECURITY
Legal Briefcase *
• 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.
19-49
 * Progress
PROGRESS ASSESSMENT Assessment

*
• 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.

19-50