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Fundamentals
of Investing
Fourteenth Edition
Global Edition
SCOTT B. SMART
Ind i a n a U n i v e r s i t y
CHAD J. ZUTTER
Univ e r s i t y o f P i t t s b u r g h
Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Dubai • Singapore • Hong Kong
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Copyright, Designs and Patents Act 1988.
Authorized adaptation from the United States edition, entitled Fundamentals of Investing, 14th Edition, ISBN 978-0-13-517521-7 by Scott B.
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Dedicated to
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Dr. Lawrence J. Gitman and Michael D. Joehnk,
who trusted us as coauthors and successors of Fundamentals of Investing.
SBS
CJZ
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Brief Contents
Detailed Contents 8
Preface 19
Part One Preparing to Invest
1
2
3
The Investment Environment
Securities Markets and Transactions
Investment Information and Securities Transactions
Part Two Important Conceptual Tools
4
4A
5
Return and Risk
The Time Value of Money
Modern Portfolio Concepts
Part Three Investing in Common Stocks
6
7
8
9
Common Stocks
Analyzing Common Stocks
Stock Valuation
Market Efficiency and Behavioral Finance
Part Four Investing in Fixed-Income Securities
10
11
Fixed-Income Securities
Bond Valuation
Part Five Portfolio Management
12
13
Mutual Funds and Exchange-Traded Funds
Managing Your Own Portfolio
Part Six Derivative Securities
14
15
Options: Puts and Calls
Futures Markets and Securities
35
72
116
158
194
210
257
293
335
374
418
463
506
549
588
631
Glossary 665
Index 679
Web Chapters
16
17
18
(at www.pearsonglobaleditions.com)
Investing in Preferred Stocks
Tax-Advantaged Investments
Real Estate and Other Tangible Investments
7
Contents
Part One
Preparing to Invest
Chapter 1
The Investment Environment 35
FAMOUS FAILURES
IN FINANCE
Ethical Failure—
Massaging the
Numbers 55
Opening Vignette 35
FAMOUS FAILURES
IN FINANCE
A Run for the
Money 57
Investments and the Investment Process 36
Attributes of Investments 36 / The Structure of the Investment
Process 39
Types of Investments 41
Short-Term Investments 41 / Common Stock 41 / Fixed-Income
Securities 43 / Mutual Funds 44 / Exchange-Traded Funds 45 /
Hedge Funds 45 / Derivative Securities 46 / Other Popular
Investments 47
Making Your Investment Plan 47
Writing an Investment Policy Statement 47 / Considering Personal
Taxes 49 / Investing over the Life Cycle 53 / Investing over the
Business Cycle 54
Meeting Liquidity Needs with Short-Term Investments 56
The Role of Short-Term Investments 56
Common Short-Term Investments 58 / Investment Suitability 60
Careers in Finance 61
Developing Skills for Your Career 64
Summary 66 / Discussion Questions 68 / Problems 69 / Case
Problem 1.1 70 / Case Problem 1.2 71
8
Chapter 2
Securities Markets and Transactions 72
FAMOUS FAILURES
IN FINANCE
Short Sellers Tip 60
Minutes 104
Opening Vignette 72
Securities Markets 73
Types of Securities Markets 73 / Broker Markets and Dealer
Markets 80 / Electronic and High-Frequency Trading 86 /
General Market Conditions: Bull or Bear 88
Contents
Globalization of Securities Markets 89
Growing Importance of International Markets 90 / International
Investment Performance 90 / Ways to Invest in Foreign
Securities 90 / Risks of Investing Internationally 91
Trading Hours and Regulation of Securities Markets 93
Trading Hours of Securities Markets 93 / Regulation of Securities
Markets 93
Basic Types of Securities Transactions 95
Long Purchase 96 / Margin Trading 96 / Short Selling 102
Summary 106 / Discussion Questions 109 / Problems 109 / Case
Problem 2.1 114 / Case Problem 2.2 115
Chapter 3
Investment Information and Securities
Transactions 116
FAMOUS FAILURES
IN FINANCE
Robbing Shareholders
to Pay Paul 140
Opening Vignette 116
Investment Research and Planning 117
Getting Started in Investment Research 117 / A Word of Caution
About Internet Trading 120
Types and Sources of Investment Information 121
Types of Information 123 / Sources of Information 123
Understanding Market Averages and Indexes 132
Stock Market Averages and Indexes 132 / Bond Market Indicators 136
Making Securities Transactions 137
The Role of Stockbrokers 137 / Basic Types of Orders 141 /
Online Transactions 143 / Transaction Costs 144 / Investor
Protection: SIPC and Arbitration 145
Investment Advisors and Investment Clubs 147
Using an Investment Advisor 147 / Investment Clubs 148
Summary 149 / Discussion Questions 152 / Problems 153 / Case
Problem 3.1 156 / Case Problem 3.2 157
Part Two
Important Conceptual Tools
Chapter 4
Return and Risk 158
FAMOUS FAILURES
IN FINANCE
Fears of Deflation
Worry Investors 162
Opening Vignette 158
The Concept of Return 159
Components of Return 159 / Why Return Is Important 160 / Level
of Return 161 / Historical Returns 163 / The Time Value of
Money and Returns 163
9
10
Contents
Measuring Return 165
Real, Risk-Free, and Required Returns 166 / Holding Period
Return 168 / The Internal Rate of Return 170 / Finding Growth
Rates 172
Risk: The Other Side of the Coin 174
Sources of Risk 174 / Risk of a Single Asset 177 / Assessing
Risk 180 / Steps in the Decision Process: Combining Return
and Risk 183
Summary 184 / Discussion Questions 186 / Problems 186 / Case
Problem 4.1 191 / Case Problem 4.2 192 / Chapter-Opening
Problem 193
Appendix 4A
The Time Value of Money 194
Opening Vignette 194
Interest: The Basic Return to Savers 194
Simple Interest 194 / Compound Interest 194
Computational Aids for Use in Time Value Calculations 196
Financial Calculators 196 / Computers and Spreadsheets 197
Future Value: An Extension of Compounding 197
Future Value of an Annuity 199
Present Value: An Extension of Future Value 200
Present Value of a Stream of Returns 202
Present Value of a Mixed Stream 203 / Present Value of an
Annuity 204
Summary 205 / Problems 205
Chapter 5
Modern Portfolio Concepts 210
FAMOUS FAILURES
IN FINANCE
Bulging Betas 227
Opening Vignette 210
Principles of Portfolio Planning 211
Portfolio Objectives 211 / Portfolio Return and Standard
Deviation 211 / Correlation and Diversification 214 /
International Diversification 221
The Capital Asset Pricing Model 223
Components of Risk 223 / Beta: A Measure of Undiversifiable
Risk 224 / The CAPM: The Connection Between Beta and
Expected Return 227
Contents
11
Traditional Versus Modern Portfolio Management 230
The Traditional Approach 230 / Modern Portfolio
Theory 232 / Reconciling the Traditional Approach and
MPT 236
Summary 237 / Discussion Questions 239 / Problems 241 / Case
Problem 5.1 250 / Case Problem 5.2 251 / Chapter-Opening Problem 253
CFA Exam Questions 255
Part Three
Investing in Common Stocks
Chapter 6
Common Stocks 257
FAMOUS FAILURES
IN FINANCE
Beware of the
Lumbering Bear 259
Opening Vignette 257
What Stocks Have to Offer 258
The Appeal of Common Stocks 258 / Putting Stock Price
Behavior in Perspective 258 / A Real Estate Bubble Goes Bust
and So Does the Market 260 / The Pros and Cons of Stock
Ownership 260
Basic Characteristics of Common Stock 263
Common Stock as a Corporate Security 263 / Buying and Selling
Stocks 266 / Common Stock Values 267
Common Stock Dividends 269
The Dividend Decision 270 / Types of Dividends 271 / Dividend
Reinvestment Plans 273
Types and Uses of Common Stock 274
Types of Stocks 274 / Investing in Foreign Stocks 277 /
Alternative Investment Strategies 281
Summary 284 / Discussion Questions 286 / Problems 287 /
Case Problem 6.1 290 / Case Problem 6.2 291
Chapter 7
Analyzing Common Stocks 293
FAMOUS FAILURES
IN FINANCE
Staying on Top a
Challenge for Fund
Managers 296
Opening Vignette 293
FAMOUS FAILURES
IN FINANCE
Cooking the Books:
What Were They
Thinking? 309
Security Analysis 294
Principles of Security Analysis 294 / Who Needs Security
Analysis in an Efficient Market? 295
Economic Analysis 296
Economic Analysis and the Business Cycle 297 / Key Economic
Factors 298 / Developing an Economic Outlook 299
12
Contents
Industry Analysis 302
Key Issues 302 / Developing an Industry Outlook 303
Fundamental Analysis 304
The Concept 304 / Financial Statements 305 / Financial
Ratios 308 / Interpreting the Numbers 320
Summary 324 / Discussion Questions 326 / Problems 326 / Case
Problem 7.1 332 / Case Problem 7.2 333 / Chapter-Opening Problem 334
Chapter 8
Stock Valuation 335
FAMOUS FAILURES
IN FINANCE
P/E Ratios Can Be
Misleading 340
Opening Vignette 335
FAMOUS FAILURES
IN FINANCE
Ethical Conflicts Faced
by Stock Analysts:
Don’t Always Believe
the Hype 348
Valuation: Obtaining a Standard of Performance 336
Valuing a Company Based on Its Future Performance 336 /
Developing a Forecast of Universal’s Financial Performance 343 /
The Valuation Process 345
Stock Valuation Models 346
The Dividend Valuation Model 347 / Other Approaches to Stock
Valuation 355 / Other Price-Relative Procedures 359
Summary 362 / Discussion Questions 364 / Problems 365 / Case
Problem 8.1 371 / Case Problem 8.2 372 / Chapter-Opening Problem 373
Chapter 9
Market Efficiency and Behavioral Finance 374
FAMOUS FAILURES
IN FINANCE
Loss Aversion and
Trading Volume 389
Opening Vignette 374
FAMOUS FAILURES
IN FINANCE
Buying High and
Selling Low 392
Efficient Markets 375
The Efficient Markets Hypothesis 378 / Market
Anomalies 383 / Possible Explanations 386
Behavioral Finance: A Challenge to the Efficient Markets
Hypothesis 387
Investor Behavior and Security Prices 387 / Implications of
Behavioral Finance for Security Analysis 395
Technical Analysis 396
Measuring the Market 396 / Trading Rules and Measures 399 /
Charting 402
Summary 406 / Discussion Questions 408 / Problems 409 / Case
Problem 9.1 413 / Case Problem 9.2 415
CFA Exam Questions 416
Contents
Part Four
Investing in Fixed-Income Securities
Chapter 10
Fixed-Income Securities 418
FAMOUS FAILURES
IN FINANCE
Rating Agencies Miss
a Big One 432
Opening Vignette 418
FAMOUS FAILURES
IN FINANCE
Yield Spreads
Approach Records 435
FAMOUS FAILURES
IN FINANCE
Implicit Guarantee
Might Not Be
Forever 436
Why Invest in Bonds? 419
A Brief History of Bond Prices, Returns, and Interest
Rates 419 / Exposure to Risk 424
Essential Features of a Bond 425
Bond Interest and Principal 425 / Maturity Date 426 / Principles
of Bond Price Behavior 426 / Quoting Bond Prices 428 / The
Call Feature 428 / Sinking Funds 429 / Secured or Unsecured
Debt 430 / Bond Ratings 430
The Market for Debt Securities 433
Major Market Segments 434 / Specialty Issues 441 / A Global
View of the Bond Market 444
Convertible Securities 446
Convertibles as Investment Outlets 446 / Sources of
Value 449 / Measuring the Value of a Convertible 449
Summary 452 / Discussion Questions 455 / Problems 456 / Case
Problem 10.1 459 / Case Problem 10.2 460 / Chapter-Opening
Problem 462
Chapter 11
Bond Valuation 463
FAMOUS FAILURES
IN FINANCE
Signs of a
Recession 465
Opening Vignette 463
The Behavior of Market Interest Rates 464
Keeping Tabs on Market Interest Rates 464 / What Causes Rates
to Move? 465 / The Term Structure of Interest Rates and Yield
Curves 467
The Pricing of Bonds 472
The Basic Bond Valuation Model 472 / Annual Compounding 473 /
Semiannual Compounding 475 / Accrued Interest 477
Measures of Yield and Return 477
Current Yield 478 / Yield to Maturity 478 / Yield to
Call 481 / Expected Return 482 / Valuing a Bond 484
Duration and Immunization 484
The Concept of Duration 485 / Measuring Duration 485 / Bond
Duration and Price Volatility 488 / Effective Duration 489 / Uses
of Bond Duration Measures 490
13
14
Contents
Bond Investment Strategies 492
Passive Strategies 492 / Trading on Interest Rate
Forecasts 493 / Bond Swaps 493
Summary 494 / Discussion Questions 496 / Problems 497 / Case
Problem 11.1 502 / Case Problem 11.2 503
CFA Exam Questions 504
Part Five
Portfolio Management
Chapter 12
Mutual Funds and Exchange-Traded Funds 506
FAMOUS FAILURES
IN FINANCE
When Mutual Funds
Behaved Badly 512
Opening Vignette 506
FAMOUS FAILURES
IN FINANCE
Breaking the
Buck 525
The Mutual Fund Concept 507
An Overview of Mutual Funds 507 / Exchange-Traded
Funds 514 / Some Important Considerations 517 / Other Types
of Investment Companies 519
Types of Funds and Services 522
Types of Mutual Funds 522 / Investor Services 527
Investing in Mutual Funds 530
Investor Uses of Mutual Funds 530 / The Selection Process 531 /
Investing in Closed-End Funds 532 / Measuring Performance 535
Summary 540 / Discussion Questions 543 / Problems 544 / Case
Problem 12.1 547 / Case Problem 12.2 547 / Chapter-Opening
Problem 548
Chapter 13
Managing Your Own Portfolio 549
Opening Vignette 549
Constructing a Portfolio Using an Asset Allocation
Scheme 550
Investor Characteristics and Objectives 550 / Portfolio Objectives
and Policies 550 / Developing an Asset Allocation Scheme 551
Evaluating the Performance of Individual Investments 554
Obtaining Data 554 / Indexes of Investment Performance 555 /
Measuring the Performance of Investments 555 / Comparing
Performance to Investment Goals 558
Assessing Portfolio Performance 559
Measuring Portfolio Return 560 / Comparison of Return with
Overall Market Measures 563 / Portfolio Revision 566
Contents
Timing Transactions 567
Formula Plans 567 / Using Limit and Stop-Loss
Orders 571 / Warehousing Liquidity 572 / Timing Investment
Sales 572
Summary 573 / Discussion Questions 576 / Problems 578 / Case
Problem 13.1 582 / Case Problem 13.2 583
CFA Exam Questions 586
Part Six
Derivative Securities
Chapter 14
Options: Puts and Calls 588
FAMOUS FAILURES
IN FINANCE
Ethical Lapse or
Extraordinarily Good
Timing? 600
Opening Vignette 588
FAMOUS FAILURES
IN FINANCE
The Volatility
Index 605
Call and Put Options 589
Basic Features of Calls and Puts 589 / Options
Markets 592 / Stock Options 593
Options Pricing and Trading 596
The Profit Potential from Puts and Calls 596 / Intrinsic
Value 598 / What Drives Option Prices? 602 / Trading
Strategies 607
Stock-Index and Other Types of Options 614
Contract Provisions of Stock-Index Options 615 / Investment
Uses 618 / Other Types of Options 618
Summary 621 / Discussion Questions 624 / Problems 624 / Case
Problem 14.1 628 / Case Problem 14.2 629 / Chapter-Opening
Problem 630
Chapter 15
Futures Markets and Securities 631
FAMOUS FAILURES
IN FINANCE
Shady Trading at
Enron 642
Opening Vignette 631
FAMOUS FAILURES
IN FINANCE
Diving Oil Prices
Send Cal Dive into
Bankruptcy 644
The Futures Market 632
Market Structure 632 / Trading in the Futures Market 634
Commodities 637
Basic Characteristics 637 / Trading Commodities 641
Financial Futures 645
The Financial Futures Market 645 / Trading
Techniques 649 / Financial Futures and the Individual
Investor 652 / Options on Futures 652
15
16
Contents
Summary 655 / Discussion Questions 657 / Problems 658 / Case
Problem 15.1 661 / Case Problem 15.2 661
CFA Exam Questions 663
Glossary 665
Index 679
Web Chapters
(at www.pearsonglobaleditions.com)
Chapter 16
Investing in Preferred stocks
Chapter 17
tax-Advantaged Investments
Chapter 18
Real estate and other tangible Investments
About the Authors
Scott B. Smart is a finance professor and the Whirlpool Finance
Faculty Fellow at the Kelley School of Business at Indiana
University. Dr. Smart received his B.B.A. from Baylor University
and his M.A. and Ph.D. from Stanford University. His research
focuses primarily on applied corporate finance topics and has
been published in journals such as the Journal of Finance, the
Journal of Financial Economics, the Journal of Corporate
Finance, Financial Management, and others. His articles have
been cited by business publications including The Wall Street
Journal, The Economist, and Business Week. Winner of more
than a dozen teaching awards, Dr. Smart has been listed multiple
times as a top business school teacher by Business Week. He has
held Visiting Professor positions at the University of Otago and
Stanford University, and he worked as a Visiting Scholar for Intel
Corporation, focusing on that company’s mergers and acquisitions activity during the “Dot-com” boom in the late 1990s. As
a volunteer, Dr. Smart currently serves on the boards of the Indiana University Credit
Union and Habitat for Humanity. In his spare time he enjoys outdoor pursuits such
as hiking and fly fishing.
Chad J. Zutter is a finance professor and the James Allen Faculty Fellow at the Katz
Graduate School of Business at the University of Pittsburgh. Dr. Zutter received his
B.B.A. from the University of Texas at Arlington and his Ph.D. from Indiana University. His research has a practical, applied focus and has been the subject of feature
stories in, among other prominent outlets, The Economist and CFO Magazine. His
papers have been cited in arguments before the U.S. Supreme Court and in consultation with companies such as Google and Intel. Dr. Zutter won the prestigious Jensen
Prize for the best paper published in the Journal of Financial Economics and a best
paper award from the Journal of Corporate Finance, where he is currently an Associate Editor. He has won teaching awards at the Kelley School of Business at Indiana
University and the Katz Graduate School of Business at the University of Pittsburgh.
Dr. Zutter also serves on the board of Lutheran SeniorLife, and prior to his career in
academics, he was a submariner in the U.S. Navy. Dr. Zutter and his wife have four
children and live in Pittsburgh, Pennsylvania. In his free time he enjoys horseback
riding and downhill skiing.
17
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Preface
New to this Edition
Just as in all of our previous editions, we aim to stay current in the field of investments
and to continue to craft a book that will truly meet the needs of students and professors.
In every chapter, our changes were designed to make the material more up to date
and more relevant for students. A number of new topics have been added at appropriate places, and new features appear in each chapter of the fourteenth edition:
• New author videos of solutions to all in-text examples that students can see on
MyLab Finance within the eText or Multimedia Library help them increase their
understanding of the concept and application being demonstrated by the in-text
example and act as a guide for the end-of-chapter problems or related assignments made by their professors.
• New GeoGebra animations for select in-chapter figures allow students to manipulate key model inputs to illustrate concepts and reinforce learning.
• A number of end-of-chapter problems are now offered in MyLab Finance as
auto-graded Excel Projects. Using proven, field-tested technology, auto-graded
Excel Projects allow instructors to seamlessly integrate Microsoft Excel content
into their course without having to manually grade spreadsheets. Students have
the opportunity to practice important finance skills in Excel, helping them to
master key concepts and gain proficiency with the program.
• New Excel templates for many end-of-chapter problems are available in MyLab
Finance. These templates do not solve problems for students but rather help
students reach a solution faster by inputting data for them or by organizing facts
presented in problems in a logical way.
• Student and instructor versions of the Excel Screenshots that appear throughout
the chapters are available in MyLab Finance. Student versions only allow students to manipulate the input values, whereas instructors’ Excel files available
in the instructor resources area provide full access to the spreadsheet models.
• Updated financial calculator images better match the financial calculator available on MyLab Finance.
• Revised or replaced chapter openers and related end-of-chapter problems in every chapter help students see the real-world application of chapter content.
• New author videos introduce the main ideas of each chapter and highlight the
application of key concepts and the connections between chapters.
• Expanded use of real-world data in examples, tables, figures, and end-of-chapter problems gives the text a more applied, practical feel and helps students
understand that the skills they learn can help them personally or on the job.
• Updated Investor Facts boxes from the previous edition, and new ones to this
edition, provide depth and breadth and again highlight the importance of investments concepts in the real world.
19
20
PRefACe
• A large percentage of the end-of-chapter problems were revised using interest
rates, stock prices, and other values that better reflect market conditions at the
time of the revision.
The Fundamentals of Investing Program
“Great firms aren’t great investments unless the price is right.” Those words of
wisdom come from none other than Warren Buffett, who is, without question, one
of the greatest investors ever. The words of Mr. Buffett sum up very nicely the essence
of this book—namely, to help students learn to make informed investment decisions,
not only when buying stocks but also when investing in bonds, mutual funds, or any
other type of investment.
To enhance learning, we recommend pairing the text content with MyLab Finance,
which is the teaching and learning platform that empowers students’ independent
learning. By combining trusted author content with digital tools and a flexible platform, MyLab personalizes the learning experience and will help students learn and
retain key course concepts while developing skills that future employers are seeking in
their candidates. From author videos to Excel Projects, MyLab Finance helps you
teach your course, your way. Learn more at www.pearson.com/mylab/finance
Solving Teaching and Learning Challenges
The fact is, investing may sound simple, but it’s not. Investors in today’s turbulent financial markets confront many challenges when deciding how to invest their
money. More than a decade after the 2008 meltdown in financial markets, investors
are still more wary of risk than they were before the crisis. This book is designed to
help students understand the risks inherent in investing and to give them the tools
they need to answer the fundamental questions that help shape a sound investment
strategy. For example, students want to know, what are the best investments for me?
Should I buy individual securities, mutual funds, or exchange-traded funds? How
do I make judgments about risk? Do I need professional help with my investments,
and can I afford it? Clearly, investors need answers to questions like these to make
informed decisions.
The language, concepts, and strategies of investing are foreign to many. To become
informed investors, students must first become conversant with the many aspects of
investing. Building on that foundation, they can learn how to make informed decisions
in the highly dynamic investment environment. This fourteenth edition of Fundamentals
of Investing provides the information and guidance needed by individual investors to
make such informed decisions and to achieve their investment goals.
This book meets the needs of professors and students in the first investments
course offered at colleges and universities, junior and community colleges,
professional certification programs, and continuing education courses. Focusing on
both individual securities and portfolios, Fundamentals of Investing explains how
to develop, implement, and monitor investment goals after considering the risk and
return of different types of investments. A conversational tone and liberal use of
examples guide students through the material and demonstrate important points.
Hallmarks of Fundamentals of Investing
Using information gathered from academicians and practicing investment professionals, plus feedback from adopters, the fourteenth edition reflects the realities of
PRefACe
21
today’s investment environment. At the same time, the following characteristics provide a structured framework for successful teaching and learning.
Clear Focus on the Individual Investor. The focus of Fundamentals of Investing
has always been on the individual investor. This focus gives students the information they need to develop, implement, and monitor a successful investment program. It also provides students with a solid foundation of basic concepts, tools, and
techniques. Subsequent courses can build on that foundation by presenting the advanced concepts, tools, and techniques used by institutional investors and money
managers.
Comprehensive yet Flexible Organization. The text provides a firm foundation
for learning by first describing the overall investment environment, including the
various investment markets, information, and transactions. Next, it presents conceptual tools needed by investors—the concepts of return and risk and the basic
approaches to portfolio management. It then examines the most popular types of
investments—common stocks, bonds, and mutual funds. Following this series of
chapters on investments is a chapter on how to construct and administer one’s own
portfolio. The final section of the book focuses on derivative securities—options
and futures—which require more expertise. Although the first two parts of the textbook are best covered at the start of the course, instructors can cover particular
investment types in just about any sequence. The comprehensive yet flexible nature
of the book enables instructors to customize it to their own course structure and
teaching objectives.
We have organized each chapter according to a decision-making perspective,
and we have been careful always to point out the pros and cons of the various
investments and strategies we present. With this information, individual investors
can select the investment actions that are most consistent with their objectives. In
addition, we have presented the various investments and strategies in such a way
that students learn the decision-making implications and consequences of each
investment action they contemplate.
Timely Topics. Current events, changing regulations, and other factors constantly reshape financial markets and investments. Virtually all topics in this book take
into account changes in the investment environment. For example, several chapters that emphasize the tax consequences of an investment or strategy incorporate
the latest tax changes passed in the United States of America as part of the Tax
Cuts and Jobs Act in December 2017. In Chapter 2, we discuss how securities
trading has changed in recent years, and we highlight the Spotify direct listing IPO
as a potential threat to the traditional underwriting business of investment banks.
Chapter 3 shares some advice from the Securities and Exchange Commission on
the perils of investing in cryptocurrencies. Chapter 5 offers expanded content on
the concept of correlation, using data on real companies to illustrate how correlation affects the performance of a portfolio. These are but a few of the examples of
new content found throughout the text.
In addition, the fourteenth edition provides students access to short video clips
from professional investment advisors. In these clips, which are carefully integrated into
the content of each chapter, students will hear professionals sharing the lessons that they
have learned through years of experience working as advisors to individual investors.
22
PRefACe
Globalization. One issue that is reshaping the world of investing is the growing globalization of securities markets. As a result, Fundamentals of Investing continues to
stress the global aspects of investing. We initially look at the growing importance of
international markets, investing in foreign securities (directly or indirectly), international investment performance, and the risks of international investing. In later chapters, we describe popular international investment opportunities and strategies as
part of the coverage of each specific type of investment vehicle. This integration of
international topics helps students understand the importance of maintaining a global focus when planning, building, and managing an investment portfolio. Global topics are highlighted by a globe icon in the margin.
Comprehensive, Integrated Learning System. The
1
Learning Goal system begins each chapter with six
Learning Goals, labeled with numbered icons. These
goals anchor the most important concepts and techniques to be learned. The Learning Goal icons are then
tied to key points in the chapter’s structure, including:
The Investment Environment
MyLab Finance Chapter Introduction Video
LEARNING GOALS
After studying this chapter, you should be able to:
Understand the meaning of the term investment and list the attributes that distinguish one
investment from another.
Describe the investment process and types of investors.
Discuss the principal types of investments.
Describe the purpose and content of an investment policy statement, review fundamental
tax considerations, and discuss investing over the life cycle.
Describe the most common types of short-term investments.
Describe some of the main careers available to people with financial expertise and the role
that investments play in each.
Y
ou have worked hard for your money. Now it is time to make your money work for you.
Welcome to the world of investments. There are literally thousands of investments, from
all around the world, from which to choose. How much should you invest, when should
you invest, and which investments are right for you? The answers depend upon the knowledge
and financial circumstances of each investor.
Financial news is plentiful, and finding financial information has become easier than ever.
Traditional media outlets, including TV networks such as CNBC, Bloomberg Television, and
Fox Business Network and print-based powerhouses such as The Wall Street Journal and The
Financial Times, provide financial advice for individual investors. However, more people obtain investment information from the Internet than from all other sources combined. The Internet makes
enormous amounts of information readily available, enables investors to trade securities with the
click of a mouse, and provides free and low-cost access to tools that were once restricted to professional investors. All of this helps create a more level playing field—yet at the same time, such
easy access can increase the risks for inexperienced investors.
Whether you are an experienced investor or a novice, the same investment fundamentals
apply. Perhaps the most fundamental principle in investing, and one that you would be wise to
keep in mind whenever you invest, is this—there is a tradeoff between an investment’s risk and
its return. Most people would like their investments to be as profitable as possible, but there is an
almost unavoidable tendency for investments with the greatest profit potential to be associated
with the highest risk. You will see examples of the link between risk and return throughout this
text. First, we address the question, “What is an investment?”
35
•
First-level headings
•
Summary
•
Discussion Questions
•
Problems
•
Cases
This tightly knit structure provides a clear road
map for students—they know what they need to learn,
where they can find it, and whether they’ve mastered
it by the end of the chapter.
An opening story sets the stage for the content that
follows by focusing on an investment situation
involving a real company or real event, which is in
turn linked to the chapter topics. Students see the relevance of the vignette to the world of investments.
In many cases, an end-of-chapter problem draws students back to the chapter opener and asks them to
use the data in the opener to make a calculation or draw a conclusion to demonstrate what they learned in the
chapter.
PRefACe
23
Examples illustrate key concepts and applications and, new to this edition, are paired with author-created
solution videos in MyLab Finance (within the eText or Multimedia Library), as noted by the associated MyLab
Finance Solution Video callout in the text. Students can watch the author videos to increase their understanding
of the concept and application being demonstrated by the in-text example and as a guide for the end-of-chapter
problems assigned by their professors.
Example
McDonald’s
Common
Stock Return
MyLab Finance
Solution Video
Suppose you purchased a single share of McDonald’s common stock for $119.62
on January 3, 2017, the first day that the stock market was open for trading that
year. During 2017 you received $3.83 in cash dividends. At the end of the year, you
sold the stock for $172.12. You earned $3.83 in dividends and you realized a $52.50
capital gain ($172.12 sale price − $119.62 purchase price) for a total dollar return of
$56.33. On a percentage basis, the return on McDonald’s shares in 2017 is calculated
as $56.33 , $119.62 = 0.471 or 47.1%. If you continued to hold the stock rather
than sell it, you would have earned the same return, but your capital gain would
have been unrealized.
An Advisor’s Perspective consists of short video clips of professional
investment advisors discussing the investments topics covered in each
chapter. Students can access the video clips on MyLab Finance.
WATCH YOUR BEHAVIOR
Cut Your Taxes and Your Losses
Several researchers have found
that investors are very reluctant to
sell stocks that have gone down in
value, presumably because they
hope to “get even” in the future.
Holding losers rather than selling
them is often a mistake because
the tax code provides an incentive
to sell these stocks. Investors can
deduct realized investment losses
(up to a point) against other forms
of income, thereby lowering their
tax liabilities.
AN ADVISOR’S PERSPECTIVE
Rick Loek, CEO,
Calrima Financial and
Insurance Agency
“There are three financial phases
that we go through in life.”
MyLab Finance
Watch Your Behavior boxes
appear in the margins of most
chapters and highlight investment lessons gleaned from the
behavioral finance literature.
Each chapter contains a handful of Investor Facts—brief sidebar items
that give an interesting statistic or cite an unusual investment experience. These facts add a bit of seasoning to the concepts under review
and capture a real-world flavor. The Investor Facts sidebars include
material focused on topics such as art as an investment, the downgrade
of the U.S. government’s credit rating, the use of financial statements to
detect accounting fraud, and recent issues of unusual securities such as
bonds with 100-year maturities.
INVESTOR FACTS
Apple on Top A firm’s market
capitalization, which equals the
price per share times the number
of shares outstanding, is a measure of its scale. On August 2,
2018, Apple Inc. became the first
company in history with a market
capitalization above $1 trillion. It
wasn’t alone in reaching that milestone very long. Amazon.com Inc.
reached the $1 trillion mark just a
month later on September 4.
24
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Famous Failures in Finance boxes—short, boxed discussions of real-life scenarios in the investments world,
many of which focus on ethics—appear in selected chapters and on the book’s website. Many of these boxes
contain a Critical Thinking Question for class discussion, with guideline answers given in the Instructor’s Manual.
FAMOUS
FAILURES IImplicit Guarantee Might Not Be Forever
Eksportfinans to junk, cutting its rating by seven
Norway’s Eksportfinans ASA,
IN FINANCE N
a partially state-owned lender,
w
was established more than
ffour decades ago with the
support of the government to provide long-term
financing for the export sector. In a surprise move
on 18th November 2011, the government decided
to wind down Eksportfinans ASA, after denying the
lender permission to waive European Union capital
requirements to prevent concentration of loans to
single industries.
After the government withdrew support, Moody’s Investors Service downgraded
points. Even though the Norwegian Trade Minister
stated that the downgrade does not reflect the
company’s ability to pay its debts, the ratings
cut sent yields surging on debt from Norway’s
biggest banks and other state-backed lenders.
Credit default swaps on sovereign debt issued
by Norway were also affected, increasing as
investors became nervous. In 10 days, the yield
on Eksportfinans’s benchmark two-year note
surged 6.76 percentage points.
These events were a good reminder that there
is risk even in AAA rated countries like Norway.
Key Equations are screened in yellow throughout the text to help readers identify the most important mathematical relationships. Select key equations also appear in the text’s rear endpapers.
Equation 10.1
Taxable equivalent yield =
Excel Screenshots Many chapters
provide screenshots showing completed
Excel models designed to solve inchapter examples. The MyLab Excel
icon indicates that student versions of
these screenshots are available in
MyLab Finance.
Yield on municipal bond
1- Marginal federal tax rate
PRefACe
Calculator Keystrokes At appropriate spots in the text the student will find
sections on the use of financial calculators, with marginal calculator graphics that show the inputs and functions to be used. The MyLab financial
calculator callout in the text indicates that the reader can use the financial
calculator tool in MyLab Finance to find the solution for an example by
inputting the keystrokes shown in the calculator screenshot.
25
MyLab Finance
Financial Calculator
Input Function
21100
CF0
90
CF1
100
CF2
110
CF3
120
CF4
CF5
CF6
CF7
100
100
1200
CPT
IRR
Solution
9.32
CPT
RCL
ENTER
CPT
CF
NPV
IRR
DEL
CPT
INS
N
I/Y
PV
PMT
FV
C/Y
P/Y
xP/Y
BGN
AMORT
1/x
x
y
7
8
9
/
4
5
6
*
1
2
3
–
0
.
=
+
C/CE
RESET
+/–
Concepts in Review questions appear at the end of each section of the chapter. These review questions allow
students to test their understanding of each section before moving on to the next section of the chapter.
Answers for these questions are available in the Multimedia Library of MyLab Finance, at the book’s
website, and by review of the preceding text.
CONCEPTS
IN REVIEW
Answers available at
http:// www.pearson.com
/mylab/finance
10.1 What appeal do bonds hold for investors? Give several reasons why bonds make
attractive investment outlets.
10.2 How would you describe the behavior of market interest rates and bond returns
over the past 50 years? Do swings in market interest rates have any bearing on
bond returns? Explain.
10.3 Identify and briefly describe the five types of risk to which bonds are exposed. What
is the most important source of risk for bonds in general? Explain.
The end-of-chapter summary makes
Fundamentals of Investing an efficient study tool by integrating
chapter contents with online Study
Plans available in MyLab Finance.
A thorough summary of the key
concepts—What You Should
Know—is directly linked with the
text and online resources—Where
to Practice.
Learning Goal icons precede each
summary item, which begins with a
boldfaced restatement of the
learning goal.
26
PRefACe
Discussion Questions, keyed to
Learning Goals, guide students to
integrate, investigate, and analyze
the key concepts presented in the
chapter. Many questions require
that students apply the tools and
techniques of the chapter to
investment information they have
obtained and then make a recommendation with regard to a specific
investment strategy or vehicle.
These project-type questions are far
broader than the Concepts in
Review questions within the
chapter. Answers to Discussion
Questions are available for instructors in the Instructor’s Manual on
the Instructor’s Resource Center.
Expanded and Revised Problem
Sets offer additional review and
homework opportunities and are
keyed to Learning Goals. Answers/
solutions are available for instructors in the Instructor’s Manual on
the Instructor’s Resource Center.
Discussion Questions
Q10.1 Using the bond returns in Table 10.1 as a basis of discussion:
a. Compare the total returns on Treasury bonds during the 1970s with those produced in the 1980s. How do you explain the differences?
b. How did the bond market do in the 1990s? How does the performance in this decade compare with that in the 1980s? Explain.
c. What do you think would be a reasonable rate of return from bonds in the future?
Explain.
d. Assume that you’re out of school and hold a promising, well-paying job. How
much of your portfolio (in percentage terms) would you want to hold in bonds?
Explain. What role do you see bonds playing in your portfolio, particularly as you
go further and further into the future?
Q10.2 Identify and briefly describe each of the following types of bonds:
a. Treasury Inflation-Protected Securities (TIPS)
b. Corporate bonds
c. Zero-coupon bonds
d. Asset-backed securities
e. Eurodollar bonds
f. PIK bonds
What type of investors do you think would be most attracted to each?
Q10.3 What do ratings agencies do? Why is it important for an investor to take a bond rating
into account before determining the value of a fixed-income asset?
Problems
Select problems are available in MyLab Finance. The X icon indicates problems in Excel format
MyLab
available in MyLab Finance.
P10.1 A 7%, five-year bond is callable in two years at a call price of $2,000. The bond is currently priced in the market at $1,770. Assuming that the call value and the maturity
value are the same, what is the issue’s current yield?
P10.2 A certain bond has a current yield of 8.1% and a market price of $925.50. What is the
bond’s coupon rate?
P10.3 Connor buys a 12% corporate bond with a current yield of 8%. How much did he pay
for the bond?
New! Indicated by the MyLab
P10.4 An investor is in the 24% tax bracket and lives in a state with no income tax. He is
X
trying to decide which of two bonds to purchase. One is a 7% corporate bond that is
Excel icon, Excel templates for
selling at par. The other is a municipal bond with a 5% coupon that is also selling at
par. If all other features of these bonds are comparable, which should the investor
many end-of-chapter Problems are
select? Why? Would your answer change if this were an in-state municipal bond and
available in MyLab Finance. These
the investor lived in a place with high state income taxes? Explain.
templates do not solve problems for
P10.5 An investor lives in a state with a 5% tax rate. Her federal income tax bracket is 28%.
X
She wants to invest in one of two bonds that are similar in terms of risk (and both
students, but rather help students
reach a solution faster by inputting
data for them or by organizing facts
presented in problems in a logical way. In addition, in this edition we provide electronic Excel-based versions
of many in-text tables, so students can see how the calculations in the tables work, and they can alter the
baseline assumption in the printed tables to see how changing assumptions affects the main results of each
table. In Chapter 1 students are directed to the website www.pearson.com/mylab/finance, where they can
complete a spreadsheet tutorial, if needed.
MyLab
MyLab
PRefACe
Two Case Problems, keyed to the
Learning Goals, encourage students to
use higher-level critical thinking skills:
to apply techniques presented in the
chapter, to evaluate alternatives, and
to recommend how an investor might
solve a specific problem. Again,
Learning Goals show the student the
chapter topics on which the case problems focus.
CFA Exam Questions from the 2010
Case Problem 10.1
27
Max and Veronica Develop a Bond Investment Program
Max and Veronica Shuman, along with their teenage sons Terry and Thomas, live in Portland,
Oregon. Max is a sales rep for a major medical firm, and Veronica is a personnel officer at a
local bank. Together they earn an annual income of about $100,000. Max has just learned that
his recently departed rich uncle has named him in his will to the tune of some $250,000 after
taxes. Needless to say, the family is elated. Max intends to spend $50,000 of his inheritance on
a number of long-overdue family items (like some badly needed remodeling of their kitchen and
family room, the down payment on a new Porsche Boxster, and braces to correct Tom’s overbite). Max wants to invest the remaining $200,000 in various types of fixed-income securities.
Max and Veronica have no unusual income requirements or health problems. Their only
investment objectives are that they want to achieve some capital appreciation, and they want
to keep their funds fully invested for at least 20 years. They would rather not have to rely on
their investments as a source of current income but want to maintain some liquidity in their
portfolio just in case.
Questions
a. Describe the type of bond investment program you think the Shuman family should
follow. In answering this question, give appropriate consideration to both return and
risk factors.
Level One Curriculum and the CFA
b. List several types of bonds that you would recommend for their portfolio and briefly
indicate why you would recommend each.
Candidate Study Notes, Level 1,
Volume 4 are now at the end of each
part of the book, starting at Part Two.
Due to the nature of the material in
some of the early chapters, the CFA
Investing in Common Stocks
questions for Parts One and Two are
Following is a sample of 11 Level-I CFA exam questions that deal with many topics covered
in Chapters 6, 7, 8, and 9 of this text, including the use of financial ratios, various stock valucombined and appear at the end of
ation models, and efficient market concepts. (Note: When answering some of the questions,
remember: “Forward P/E” is the same as a P/E based on estimated earnings one year out.)
When answering the questions, give yourself 1½ minutes for each question; the objective is to
Part Two. These questions offer
correctly answer 8 of the 11 questions in a period of 16½ minutes.
students an opportunity to test their
1. Holding constant all other variables and excluding any interactions among the determinants of value, which of the following would most likely increase a firm’s price-toearnings multiple?
investment knowledge against that
a. The risk premium increases.
b. The retention rate increases.
required for the CFA Level-I exam.
c. The beta of the stock increases.
2. A rationale for the use of the price-to-sales (P/S) approach is:
In MyLab Finance on the Course
a. Sales are more volatile than earnings.
b. P/S ratios assess cost structures accurately.
c. Revenues are less subject to accounting manipulation than earnings.
Home page, there are three Sample
3. A cyclical company tends to
CFA Exams. Each of these exams is
a. have earnings that track the overall economy.
b. have a high price-to-earnings ratio.
c. have less volatile earnings than the overall market.
patterned after the CFA Level-I exam
4. Consider a company that earned $4.00 per share last year and paid a dividend of $1.00.
The firm has maintained a consistent payout ratio over the years and analysts expect this
and comes with detailed guideline
to continue. The firm is expected to earn $4.40 per share next year, and the stock is expected to sell for $30.00. The required rate of return is 12%. What is the best estimate of
answers. The exams deal only with
the stock’s current value?
a. $44.00
topics that are actually covered in the
b. $22.67
c. $27.77
fourteenth edition of Fundamentals of
5. A stock’s current dividend is $1 and its expected dividend is $1.10 next year. If the investor’s required rate of return is 15% and the stock is currently trading at $20.00, what is
Investing and are meant to replicate as
the implied expected price in one year?
a. $21.90
b. $22.00
closely as possible the types of quesc. $23.00
tions that appear on the standard
6. A firm has total revenues of $187,500, net income of $15,000, total current liabilities
of $50,000, total common equity of $75,000, and total assets of $150,000. What is the
firm’s ROE?
Level-I Exam. The Sample CFA Exams
a. 15%
b. 20%
on MyLab Finance come in three
c. 24%
lengths: 30 questions, 40 questions,
and 50 questions. Each exam is
unique and consists of a different set of questions, so students can take any one or all of the exams without
running into any duplicate questions. For the most part, these questions are adapted from past editions of
the CFA Candidate Study Notes. Answers are included for immediate reinforcement.
C FA E x a m Q u e s t i o n s
28
PRefACe
Additional MyLab Finance Features
A Powerful Homework and Test Manager. A powerful homework and test manager lets you create, import, and manage online homework assignments, quizzes,
and tests that are automatically graded. You can choose from a wide range of assignment options, including time limits, proctoring, and maximum number of attempts
allowed. The bottom line: MyLab Finance means less time grading and more time
teaching.
Study Plan. The Study Plan gives personalized recommendations for each student,
based on his or her ability to master the learning objectives in your course. This allows students to focus their study time by pinpointing the precise areas they need to
review, and allowing them to use customized practice and learning aids—such as
videos, eTexts, tutorials, and more—to help students stay on track.
Pearson eText. Pearson eText enhances learning—both in and out of the classroom.
Students can take notes, highlight, and bookmark important content, or engage with
interactive lecture and example videos that bring learning to life (available with select titles) anytime, anywhere via MyLab or the app. Pearson eText enhances
learning—both in and out of the classroom. Worked examples, videos, and interactive tutorials bring learning to life, while algorithmic practice and self-assessment
opportunities test students’ understanding of the material—anytime, anywhere via
MyLab or the app.
Learning Management System (LMS) Integration. You can now link from Black-
board Learn, Brightspace by D2L, Canvas, or Moodle to MyLab Finance. Access
assignments, rosters, and resources, and synchronize grades with your LMS gradebook. For students, single sign-on provides access to all the personalized learning
resources that make studying more efficient and effective.
Excel Projects. Using proven, field-tested technology, auto-graded Excel Projects
let you seamlessly integrate Microsoft Excel content into your course without having
to manually grade spreadsheets. Students can practice important statistical skills in
Excel, helping them master key concepts and gain proficiency with the program.
They simply download a spreadsheet, work live on a statistics problem in Excel, and
then upload that file back into MyLab Finance. Within minutes, they receive a report
that provides personalized, detailed feedback to pinpoint where they went wrong in
the problem.
Financial Calculator. Students can access a fully functional Financial Calculator
inside MyLab Finance and a financial calculator app that they can download to their
iPhone®, iPad®, or Android device—so they can perform financial calculations and
complete assignments, all in the same place.
PRefACe
29
Question Help. Question Help consists of homework and practice questions to give
students unlimited opportunities to master concepts. If students get stuck, learning
aids like Help Me Solve This, View an Example, eText Pages, and a Financial Calculator walk them through the problem and show them helpful info in the text—giving
them assistance when they need it most.
Worked Out Solutions. Worked Out Solutions are available to students when they
are reviewing their submitted and graded homework. They provide step-by-step explanations on how to solve the problem using the exact numbers and data presented
in the original problem. Instructors have access to Worked Out Solutions in preview
and review mode.
Visit www.pearson.com/mylab/finance to access all the available features included
with the fourteenth edition of Fundamentals of Investing.
Developing Employability Skills
For students to succeed in a rapidly changing job market, they should be aware of
their career options and how to go about developing skills that prepare them to
pursue those career opportunities. In this book and in MyLab Finance, we focus on
developing these skills in a variety of ways.
Excel modeling skills—Each chapter offers students opportunities to work with
Excel spreadsheets available on MyLab to build Excel models to solve investment
problems. Many chapters provide Excel screenshots showing completed models
designed to solve in-chapter examples.
Ethical reasoning skills—The Famous Failures in Finance boxes appearing in
each chapter often highlight ethical problems arising in the investments context as
well as the potential consequences of unethical actions by investment professionals.
These boxes will help students recognize the ethical temptations they are likely to
face while pursuing an investments career or as they invest their own money.
Critical thinking skills—Nearly every significant investment decision involves critical thinking because making optimal decisions means weighing tradeoffs of alternative decisions, such as the risk/reward tradeoff inherent in making any investment. To
weigh these tradeoffs, students must first learn how to quantify them. Nearly every
chapter in this book talks about the quantitative benefits and costs of different investments, and students who master this content will be in a strong position to make
better investment decisions on behalf of their clients and themselves.
Data analysis skills—Investments is all about data. Analysts have to identify the
data that is relevant for a particular investments problem, and they must know how
to process that data in a way that leads to a good investment decision. In-chapter
examples and end-of-chapter problems require students to sort out relevant from
irrelevant data and to use the data that is available to make clear recommendations
about what course of action an investor should take.
Instructor Teaching Resources
We recognize the key role of a complete and creative package of materials to supplement a basic textbook. We believe that the following materials, offered with the fourteenth edition, will enrich the investments course for both students and instructors.
30
PRefACe
Supplements available to instructor at
www.pearsonglobaleditions.com
Features of the Supplement
Instructor’s Manual
•
•
•
•
•
Test Bank
More than 1,800 multiple-choice, true/false, short-answer, and
graphing questions with these annotations:
• Type (multiple-choice, true/false, short-answer, essay
• Topic (the term or concept the question supports)
• Learning outcome
• AACSB learning standard (written and oral communication;
ethical understanding and reasoning; analytical thinking;
information technology; interpersonal relations and teamwork;
diverse and multicultural work; reflective thinking; application
of knowledge)
Computerized TestGen
TestGen allows instructors to:
• Customize, save, and generate classroom tests
• Edit, add, or delete questions from the test item files
• Analyze test results
• Organize a database of tests and student results.
PowerPoints
PowerPoints include lecture notes, key equations, and figures and
tables from the text. In addition, these slides meet accessibility
standards for students with disabilities. Features include but are
not limited to:
• Keyboard and screen reader access
• Alternative text for images
• High color contrast between background and foreground colors
Teaching outlines
Chapter summaries
Key concepts
Chapter overviews
Solutions to all questions and problems in the text
ACknowleDGments
31
Acknowledgments
Many people gave their generous assistance during the initial development and revisions of Fundamentals of Investing. The expertise, classroom experience, and general
advice of both colleagues and practitioners have been invaluable. Reactions and suggestions from students throughout the country—comments we especially enjoy receiving—
sustained our belief in the need for a fresh, informative, and teachable investments text.
A few individuals provided significant subject matter expertise in the initial development of the book. They are Terry S. Maness of Baylor University, Arthur L.
Schwartz, Jr., of the University of South Florida at St. Petersburg, and Gary W.
Eldred. Their contributions are greatly appreciated. In addition, Pearson obtained
the advice of a large group of experienced reviewers. We appreciate their many suggestions and criticisms, which have had a strong influence on various aspects of this
volume. Our special thanks go to the following people, who reviewed all or part of
the manuscript for the previous 13 editions of the book.
Kevin Ahlgrim
M. Fall Ainina
Joan Anderssen
Felix O. Ayadi
Gary Baker
Harisha Batra
Anand K. Bhattacharya
Richard B. Bellinfante
Cecil C. Bigelow
Robert J. Boldin
Paul Bolster
Denis O. Boudreaux
A. David Brummett
Gary P. Cain
Gary Carman
Daniel J. Cartell
P. R. Chandy
Steven P. Clark
William Compton
David M. Cordell
Timothy Cowling
Robert M. Crowe
James DeMello
Richard F. DeMong
Clifford A. Diebold
Steven Dolvin
James Dunn
Betty Marie Dyatt
Scott Ehrhorn
Steven J. Elbert
Robert Eldridge
Imad Elhaj
Thomas Eyssell
Frank J. Fabozzi
Robert A. Ford
Albert J. Fredman
John Gerlach
Tom Geurts
Chaim Ginsberg
Joel Gold
Terry Grieb
Frank Griggs
Brian Grinder
Arthur S. Guarino
Harry P. Guenther
Tom Guerts
John Guess
Matthew Haertzen
Robert Hartwig
Mahboubul Hassan
Gay Hatfield
Dan Hess
Robert D. Hollinger
Sue Beck Howard
Ping Hsiao
Roland Hudson, Jr.
Raad Jassim
Donald W. Johnson
Samuel Kyle Jones
Jeffrey Jones
Rajiv Kalra
Ravindra R. Kamath
Bill Kane
Daniel J. Kaufmann, Jr.
Burhan Kawosa
Nancy Kegelman
Phillip T. Kolbe
Sheri Kole
Christopher M. Korth
Marie A. Kratochvil
Thomas M. Krueger
Wendy Ku
Lynn Kugele
George Kutner
Blake LeBaron
Robert T. LeClair
Chun I. Lee
William Lepley
Steven Lifland
Ralph Lim
James Lock
Larry A. Lynch
Barry Marchman
Weston A. McCormac
David J. McLaughlin
Anne Macy
James Mallett
Keith Manko
Timothy Manuel
Kathy Milligan
Warren E. Moeller
Homer Mohr
Majed R. Muhtaseb
Joseph Newhouse
Michael Nugent
Joseph F. Ollivier
Michael Palermo
John Palffy
James Pandjiris
John Park
Thomas Patrick
Michael Polakoff
Barbara Poole
Ronald S. Pretekin
Stephen W. Pruitt
Mark Pyles
S. P. Umamaheswar Rao
Rathin Rathinasamy
William A. Richard
Linda R. Richardson
William A. Rini
Roy A. Roberson
Tammy Rogers
Edward Rozalewicz
William J. Ruckstuhl
David Russo
Arthur L. Schwartz, Jr.
William Scroggins
Daniel Singer
Keith V. Smith
Pat R. Stout
Nancy E. Strickler
Glenn T. Sweeney
Amir Tavakkol
Phillip D. Taylor
Wenyuh Tsay
Robert C. Tueting
Howard E. Van Auken
P. V. Viswanath
Doug Waggle
Hsinrong Wei
John R. Weigel
Sally Wells
Peter M. Wichert
Daniel Wolman
John C. Woods
Michael D. Woodworth
Robert J. Wright
Richard H. Yanow
Ali E. Zadeh
Edward Zajicek
Dazhi Zheng
32
ACknowleDGments
Because of the wide variety of topics covered in the book, we called upon many
experts for advice. We thank them and their firms for allowing us to draw on their
insights and awareness of recent developments to ensure that the text is as current
as possible. In particular, we want to mention Bill Bachrach, Bachrach & Associates,
San Diego, CA; John Markese, President, American Association of Individual Investors, Chicago, IL; Frank Hatheway, CFA, Chief Economist, Nasdaq, New York, NY;
George Ebenhack, Oppenheimer & Co., Los Angeles, CA; Mark D. Erwin, ChFC,
Commonwealth Financial Network, San Diego, CA; David M. Love, C. P. Eaton and
Associates, La Jolla, CA; Michael R. Murphy, Sceptre Investment Counsel, Toronto,
Ontario, Canada; Richard Russell, Dow Theory Letters, La Jolla, CA; and Michael
J. Steelman, Merrill Lynch, Bonsall, CA.
To create the video feature An Advisor’s Perspective, we relied on the generosity
of many investment professionals from around the country. We are especially thankful to David Hays of CFCI and Ed Slott of Ed Slott and Company for helping us to
do a great deal of the videotaping for this feature at the Ed Slott conference in Phoenix, Arizona. We are thankful to all of the investment professionals who participated
in this project on video:
Catherine Censullo, Founder, CMC Wealth Management
Joseph A. Clark, Managing Partner, Financial Enhancement Group
Ron Courser, CFO, Ron Courser and Associates
Bob Grace, President, Grace Tax Advisory Group
James Grant, Founder, Grant’s Interest Rate Observer
Bill Harris, Founder, WH Cornerstone Investments
James Johnson, President, All Mark Insurance Services
Mary Kusske, President, Kusske Financial Management
Rick Loek, CEO, Calrima Financial and Insurance Agency
Ryan McKeown, Senior VP, Wealth Enhancement Group
Thomas O’Connell, President, International Financial Advisory Group
Phil Putney, Owner, AFS Wealth Management
Tom Riquier, Owner, The Retirement Center
Rob Russell, CEO, Russell and Company
Carol Schmidlin, President, Franklin Planning
Ed Slott, CEO, Ed Slott and Company
Bryan Sweet, Owner, Sweet Financial Services
Steve Wright, Managing Member, The Wright Legacy Group
Special thanks go to Alan Wolk of the University of Georgia for accuracy checking the quantitative content in the textbook. We are pleased by and proud of his
efforts. Additionally, we extend our gratitude to Robert Hartwig of Worcester State
College for revising and updating the Test Bank and Instructor’s Manual, and to
Brian Nethercutt for updating and revising the PowerPoint program.
The staff at Pearson, particularly Donna Battista, Vice President of Business,
Economics, and UK Courseware, contributed their creativity, enthusiasm, and commitment to this textbook. Pearson Content Producer Meredith Gertz pulled together
the various strands of the project. Other dedicated Pearson staff, including former
Portfolio Manager Kate Fernandes, Senior Digital Studio Producer Melissa Honig,
Digital Content Team Lead for MyLab Finance Miguel Leonarte, and Senior Product Marketing Manager Kaylee Carlson warrant special thanks for shepherding the
project through the development, production, marketing, and website construction
ACknowleDGments
33
stages. Additionally, we appreciate the efforts of the extended publishing team, including Denise Forlow at Integra Software Services Inc. and Kerri Tomasso for their
oversight of the production process. Without the care and concern of all these individuals, this text would not have evolved into the teachable and interesting text and
package we believe it to be.
Finally, our wives, Susan and Heidi, played important roles by providing support and understanding during the book’s development, revision, and production.
We are forever grateful to them, and we hope that this edition will justify the sacrifices required during the many hours we were away from them working on this book.
Scott B. Smart
Chad J. Zutter
Global Edition Acknowledgments
Pearson would like to thank the following people for contributing to and reviewing the
Global Edition and sharing their insightful comments and suggestions:
CONTRIBUTORS
Rezart Erindi, Chartered Financial Analyst
REVIEWERS
Michael Humphries, Touro College, Israel Campus
Ricky Li, Cardiff Metropolitan University
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1
The Investment Environment
MyLab Finance Chapter Introduction Video
LEARNING GOALS
After studying this chapter, you should be able to:
Understand the meaning of the term investment and list the attributes that distinguish one
investment from another.
Describe the investment process and types of investors.
Discuss the principal types of investments.
Describe the purpose and content of an investment policy statement, review fundamental
tax considerations, and discuss investing over the life cycle.
Describe the most common types of short-term investments.
Describe some of the main careers available to people with financial expertise and the role
that investments play in each.
Y
ou have worked hard for your money. Now it is time to make your money work for you.
Welcome to the world of investments. There are literally thousands of investments, from
all around the world, from which to choose. How much should you invest, when should
you invest, and which investments are right for you? The answers depend upon the knowledge
and financial circumstances of each investor.
Financial news is plentiful, and finding financial information has become easier than ever.
Traditional media outlets, including TV networks such as CNBC, Bloomberg Television, and
Fox Business Network and print-based powerhouses such as The Wall Street Journal and The
Financial Times, provide financial advice for individual investors. However, more people obtain investment information from the Internet than from all other sources combined. The Internet makes
enormous amounts of information readily available, enables investors to trade securities with the
click of a mouse, and provides free and low-cost access to tools that were once restricted to professional investors. All of this helps create a more level playing field—yet at the same time, such
easy access can increase the risks for inexperienced investors.
Whether you are an experienced investor or a novice, the same investment fundamentals
apply. Perhaps the most fundamental principle in investing, and one that you would be wise to
keep in mind whenever you invest, is this—there is a tradeoff between an investment’s risk and
its return. Most people would like their investments to be as profitable as possible, but there is an
almost unavoidable tendency for investments with the greatest profit potential to be associated
with the highest risk. You will see examples of the link between risk and return throughout this
text. First, we address the question, “What is an investment?”
35
36
PART ONE
I
PREPARING TO INVEST
Investments and the Investment Process
NOTE The Learning
Goals shown at the
beginning of the chapter
are keyed to text
discussions using these
icons.
You are probably already an investor. If you have money in a savings account, you
have at least one investment to your name. An investment is any asset into which you
place funds with the expectation that it will generate positive income and/or increase
its value. A collection of different investments is called a portfolio.
The rewards, or returns, from investing come in two basic forms: income and increased value. Money invested in a savings account provides income in the form of periodic interest payments. A share of common stock may also provide income (in the form
of dividends), but investors often buy stock because they expect its price to rise. That is,
common stock offers both income and the chance of an increased value. In the United
States since 1900, the average annual return on a savings account has been a little more
than 4%. The average annual return on common stock has been about 11.5%. Of
course, during major market downturns (such as the one that occurred in 2008), the
returns on nearly all investments fall well below these long-term historical averages.
Is cash placed in a non-interest-bearing checking account an investment? No, because it fails both tests of the definition: It does not provide added income, and its
value does not increase. In fact, over time inflation erodes the purchasing power of
money left in a non-interest-bearing checking account.
Attributes of Investments
When you invest, the organization in which you invest—whether it is a company or
a government entity—offers you the prospect of a future benefit in exchange for the
use of your funds. You are giving up the use of your money, or the opportunity to
use that money to consume goods and services today, in exchange for the prospect of
having more money, and thus the ability to consume goods and services, in the future.
Organizations compete for the use of your funds, and just as retailers compete for cusNOTE Investor Facts
tomers’ dollars by offering a wide variety of products with different characteristics, oroffer interesting or
ganizations attempting to raise funds from investors offer a wide variety of investments
entertaining tidbits of
information.
with different attributes. As a result, investments of every type are available, from
virtually zero-risk savings accounts at banks, which in recent years offered returns
hovering barely above 0%, to shares of common stock in high-risk compaINVESTOR FACTS
nies that might skyrocket or plummet in a short time. The investments you
choose will depend on your resources, your goals, and your willingness to
Art as an Asset Is art a good
take risk. We can describe a number of attributes that distinguish one type
investment? Paintings and other
of investment from another.
artworks trade infrequently (i.e.,
they are illiquid), so measuring the
investment performance of art is
difficult. Using sophisticated statistical methods, one study pegged
the average annual return on art
(from 1961 to 2013) at just over
6%. That figure is higher than the
returns earned on investments in
real estate and U.S. government
securities but below returns delivered by commodities, corporate
bonds, and common stocks.
(Source: Based on “Does It Pay to
Invest In Art? A Selection-Corrected
Returns Perspective,” Review of
Financial Studies, 2016.)
Securities or Property Securities are investments issued by firms, govern-
ments, or other organizations that represent a financial claim on the issuer’s
resources. The most common securities are stocks and bonds, but more exotic types such as stock options are available as well. One benefit of investing in securities is that they often have a high degree of liquidity, meaning
that you can sell securities and convert them into cash quickly without incurring substantial transaction costs and without having an adverse impact
on the security’s price. Stocks issued by large companies, for example, tend
to be highly liquid, and investors trade billions of shares of stock each day
in the markets all over the world. The focus of this text is primarily on the
most basic types of securities.
Property, on the other hand, consists of investments in real property
or tangible personal property. Real property refers to land, buildings, and
CHAPTER 1
INVESTOR FACTS
Smart People Own Stocks The
stock market participation rate
refers to the percentage of
households that invest in stocks
directly or indirectly. A study of
investors from Sweden found
that an extra year of schooling
increased the stock market participation rate by two percentage
points and increased the share of
wealth that individuals invested
in stocks by 10%. Another study
looked at investors from Finland
and found a remarkable connection between IQ and stock market
participation—people with higher
IQ scores were much more likely
to invest in stocks than were
people with lower IQ scores. more
remarkable still, the IQ measure
used in this study was the score
on a test given to Finnish males
when they were 19 or 20 years old
as part of their induction to military
service. IQ scores measured at
that early age were a very strong
predictor of whether these men
would invest in stocks much later
in life.
I
THE INVESTmENT ENVIRONmENT
37
things permanently affixed to the land. Tangible personal property includes
items such as gold, artwork, antiques, and other collectibles. In most cases,
property is not as easy to buy or sell as are securities, so we would say that
property tends to be a relatively illiquid investment. Investors who want to
sell a building or a painting may have to hire (and compensate) a real estate
agent or an art dealer to locate a buyer, and it may take weeks or months to
sell the property.
Direct or Indirect A direct investment is one in which an investor directly
acquires a claim on a security or property. If you buy shares of common
stock in a company such as Apple, then you have made a direct investment,
and you are a part owner of that firm. An indirect investment is an investment in a collection of securities or properties managed by a professional
investor. For example, when you send your money to a mutual fund company such as Vanguard or Fidelity, you are making an indirect investment
in the assets held by these mutual funds.
Direct ownership of common stock has been on the decline in the
United States for many years. For example, in 1945 households owned
(directly) more than 90% of the common stocks listed in the United States.
Over time that percentage dropped to its current level of about 30.5% (by
comparison, 64% of U.S. households own a home). The same trend has
occurred in most of the world’s larger economies. In the United Kingdom,
for example, households’ direct ownership of shares fell from roughly 66%
to 14% in the past half century. Today, households directly hold less than
one-quarter of outstanding shares in most of the world’s major stock markets, as Figure 1.1 shows.
Just as direct stock ownership by households has been falling, indirect
(Sources: Based on “Learning to Take
ownership
has been rising. The percentage of U.S. households that owned
Risks? The Effect of Education on Risk
Taking in Financial markets,” Review
mutual funds (one means of obtaining indirect ownership of stocks and
of Finance, 2018; “IQ and Stock market
other investments) rose from about 5% in 1980 to almost 55% in 2017.
Participation,” Journal of Finance,
Individuals have indirect ownership in stocks through many other types of
2011.)
financial institutions besides mutual funds. In 1945 institutional investors
such as pension funds, hedge funds, and mutual funds combined held just
less than 2% of the outstanding stock in the United States, but today their direct ownership is approaching 70%.
Tax policy helps to explain the decline in direct stock ownership by individuals and
the related rise in direct ownership by institutions such as mutual funds and pension
funds. Starting in 1978, section 401(k) of the Internal Revenue Code allowed employees to avoid paying tax on earnings that they elect to receive as deferred compensation,
such as in a retirement savings plan. Since then, most large companies have adopted
so-called 401(k) plans, which allow employees to avoid paying current taxes on the
income that they contribute to a 401(k) plan. Employees are taxed on this income
when they withdraw it during their retirement years. Typically, mutual fund companies
manage 401(k) plans, so stocks held in these plans represent indirect ownership for the
workers and direct ownership for the mutual fund companies.
An important element of this trend is that individuals who trade stocks directly
often deal with professional investors who sell the shares those individuals want to buy
or buy what individuals want to sell. For instance, in 2018 Fidelity, one of the largest investment management companies in the world, had $2.5 trillion in assets in its
various mutual funds, trusts, and other accounts, and the company employed approximately 40,000 people, many of whom had advanced investments training and access to
38
PART ONE
I
PREPARING TO INVEST
FIGURE 1.1
Direct Stock Ownership
by Households
The figure shows the
percentage of common
stocks in each country
that is owned directly
by households. In most
countries, households own
less than one-quarter of
the value of listed common
stocks in the country.
(Source: Data from
“Government Policy and
Ownership of Equity
Securities,” Journal of
Financial Economics,
2014, Vol. 111, Issue 1,
pp. 70–85.)
30.5
United States
Canada
28.3
Australia
24
Japan
19.1
Germany
14.5
Sweden
14.3
United Kingdom
14.1
Finland
8.1
France
6.1
0
5
10
15
20
25
30
35
Percentage of Common Stocks Held by Households
a tremendous amount of information about the companies in which they invest. Given
the preponderance of institutional investors in the market today, individuals are wise
to consider the advantages possessed by the people with whom they are trading.
Debt, Equity, or Derivative Securities Most investments fall into one of three broad
categories—debt, equity, or derivatives. Debt is simply a loan that obligates the borrower to make periodic interest payments and to repay the full amount of the loan by
some future date. When companies or governments need to borrow money, they issue
securities called bonds. When you buy a bond, you lend money to the issuer. The issuer
agrees to pay you interest and to repay the original loan at a specified time.
Equity represents ongoing ownership in a business or property. An equity investment may be held as a security or by title to a specific property. The most common type
of equity security is common stock.
Derivative securities derive their value from an underlying security or asset. Stock
options are an example. A stock option is an investment that grants the right to purchase (or sell) a share of stock at a fixed price for a limited time. The option’s value
depends on the market price of the underlying stock.
Low- or High-Risk Investments Investments also differ on the basis of risk. Risk reflects the uncertainty surrounding the return that a particular investment will generate.
To oversimplify things slightly, the more uncertain the return associated with an investment, the greater its risk. One of the most important strategies that investors use to
manage risk is diversification, which simply means holding different types of assets in
an investment portfolio.
As you invest over your lifetime, you will be confronted with a continuum of investments that range from low risk to high risk. For example, stocks are generally
considered riskier than bonds because stock returns vary over a much wider range and
are harder to predict than are bond returns. However, it is not difficult to find high-risk
bonds that are riskier than the stock of a financially sound firm.
CHAPTER 1
I
THE INVESTmENT ENVIRONmENT
39
In general, investors face a tradeoff between risk and return—to obtain higher
returns, investors usually have to accept greater risks. Low-risk investments provide
a relatively predictable, but also relatively low, return. High-risk investments provide
much higher returns on average, but they also have the potential for much larger losses.
Short- or Long-Term Investments The life of an investment may be either short or
long. Short-term investments typically mature within one year. Long-term investments
are those with longer maturities or, like common stock, with no maturity at all.
Domestic or Foreign As recently as 30 years ago, U.S. citizens invested almost exNOTE Discussions of
international investing are
highlighted by this icon.
clusively in purely domestic investments: the debt, equity, and derivative securities of
U.S.-based companies and governments. The same could be said of investors in many
other countries. In the past, most people invested the vast majority of their money in
securities issued by entities located in their home countries. Today investors routinely
also look for foreign investments (both direct and indirect) that might offer more attractive returns than purely domestic investments. Even when the returns offered by
foreign investments are not higher than those found in domestic securities, investors
may still choose to make foreign investments because they help them build more diversified portfolios, which in turn helps limit exposure to risk. Information on foreign
companies is readily available, and it is relatively easy to make foreign investments.
The Structure of the Investment Process
The investment process brings together suppliers who have extra funds and demanders
who need funds. Households, governments, and businesses are the key participants in the
investment process, and each of these participants may act as a supplier or a demander of
funds at a particular time. However, there are some general tendencies. Households who
spend less than their income have savings, and they want to invest those surplus funds
to earn a return. Households, then, are generally net suppliers of funds. Governments,
on the other hand, often spend more than their tax revenues, so they issue bonds and
other debt securities to raise additional funds. Governments are typically net demanders
of funds. Businesses are also net demanders of funds most of the time. They issue debt or
equity securities to finance new investments and other activities.
Suppliers and demanders of funds usually come together by means of a financial institution or a financial market. Financial institutions are organizations, such as
banks, mutual funds, and insurance companies, that pool the resources of households
and other savers and use those funds to make loans and to invest in securities. Financial
markets are markets in which suppliers and demanders of funds trade financial assets,
typically with the assistance of intermediaries such as securities brokers and dealers.
All types of investments, including stocks, bonds, commodities, and foreign currencies,
trade in financial markets.
The dominant financial market in the United States is the securities market. It
includes stock markets, bond markets, and options markets. Similar markets exist in
most major economies throughout the world. The prices of securities traded in these
markets are determined by the interactions of buyers and sellers, just as other prices are
established in other kinds of markets. For example, if the number of Facebook shares
that investors want to buy is greater than the number that investors want to sell, the
price of Facebook stock will rise. As new information about the company becomes
available, changes in supply (investors who want to sell) and demand (investors who
want to buy) may result in a new market price. Financial markets streamline the process of bringing together buyers and sellers, so investors can transact with each other
40
PART ONE
I
PREPARING TO INVEST
quickly and inexpensively. Financial markets provide another valuable function by establishing market prices for securities that are easy for market participants to monitor.
For example, a firm that launches a new product may get an early indication of how
that product will be received in the market by seeing whether investors drive the firm’s
stock price up or down as they learn about the new product.
Figure 1.2 is a diagram of the investment process. Note that the suppliers of funds
may transfer their resources to the demanders through financial institutions, through
financial markets, or in direct transactions. As the broken lines show, financial institutions can participate in financial markets as either suppliers or demanders of funds. For
the economy to grow and prosper, funds must flow to those with attractive investment
opportunities. If individuals began suddenly hoarding their excess funds rather than putting them to work in financial institutions and markets, then organizations in need of
funds would have difficulty obtaining them. As a result, government spending, business
expansion, and consumer purchases would decline, and economic activity would slow.
When households have surplus funds to invest, they must decide whether to make
the investment decisions themselves or to delegate some or all of that responsibility to
professionals. This leads to an important distinction between two types of investors in
the financial markets. Individual investors manage their own funds to achieve their financial goals. Individuals who lack the time or expertise to make investment decisions
often employ institutional investors—investment professionals who earn their living by
managing other people’s money. These professionals trade large volumes of securities
for individuals, as well as for businesses and governments. Institutional investors include banks, life insurance companies, mutual funds, pension funds, and hedge funds.
Both individual and institutional investors apply similar fundamental principles
when deciding how to invest money. However, institutional investors generally control larger sums of money and have more sophisticated analytical skills than do most
individual investors. The information presented in this text is aimed primarily at you—
the individual investor. Mastering this material represents only the first step that you
need to take to develop the expertise you need if you want to become an institutional
investor.
FIGURE 1.2
The Investment Process
Financial institutions
participate in the financial
markets as well as transfer
funds between suppliers
and demanders. Although
the arrows go only from
suppliers to demanders,
for some transactions
(e.g., the sale of a bond
or a college loan), the
principal amount borrowed
by the demander from the
supplier (the lender) is
eventually returned.
Financial Institutions
Banks
Savings and Loans
Savings Banks
Credit Unions
Insurance Companies
Pension Funds
Suppliers
of
Funds
Direct transactions
Financial Markets
Money (short term)
Capital (long term)
Demanders
of
Funds
CHAPTER 1
CONCEPTS
IN REVIEW
Answers available at
www.pearson.com/mylab/
finance
NOTE The Concepts in
Review questions at the end
of each text section
encourage you, before you
move on, to test your
understanding of the
material you’ve just read.
I
THE INVESTmENT ENVIRONmENT
1.1
Define the term investment, and explain why individuals invest.
1.2
Differentiate among the following types of investments, and cite an example of each:
(a) securities and property investments; (b) direct and indirect investments; (c) debt,
equity, and derivative securities; and (d) short-term and long-term investments.
1.3
What is the relation between an investment’s risk and its return?
1.4
Define the term risk, and explain how risk is used to differentiate among investments.
1.5
What are foreign investments, and what role do they play for the individual investor?
1.6
Describe the structure of the overall investment process. Explain the role played by
financial institutions and financial markets.
1.7
Classify the roles of (a) government, (b) business, and (c) individuals as net suppliers
or net demanders of funds.
1.8
Differentiate between individual investors and institutional investors.
41
Types of Investments
A wide variety of investments is available to individual investors. As you have seen,
investments differ in terms of risk, maturity, and many other characteristics. We devote
the bulk of this text to describing the characteristics of different investments and the
strategies that you may use when you buy and sell these investments. Table 1.1 summarizes some basic information about the major types of investments that we will study.
Short-Term Investments
Short-term investments have a life of one year or less and usually (but not always)
carry little or no risk. People buy these investments to put idle funds to use before
transferring the money into a long-term investment. Short-term investments are also
appealing to conservative investors who are reluctant to put their funds in riskier, longterm assets such as stocks or bonds.
Short-term investments provide liquidity because investors can convert them into
cash quickly with little or no loss in value. Liquidity is important to investors because it is
impossible to know when an emergency or other unplanned event will make it necessary
to obtain cash by selling an investment. At such a time, selling an investment quickly is
important. Of course, an investor willing to sell at a bargain price can convert almost any
asset to cash quickly, but an investment that is liquid doesn’t require such a concession.
Liquid investments give investors peace of mind that they can to get their hands on cash
quickly if they need it without having to sell their investments at fire-sale prices.
Common Stock
Common stock is an equity investment that represents ownership in a corporation.
Each share of common stock represents a fractional ownership interest in the firm. For
example, in early 2018, Amazon had just over 484 million shares of stock outstanding.
If you bought 100 shares of Amazon, you would be a part owner of that company,
though your ownership stake would be just 0.000021%! Owners of common stock
usually have the right to vote at shareholders’ meetings, but for most individual investors, the voting rights are less important than the return they hope to earn.
42
PART ONE
TABLE 1.1
I
PREPARING TO INVEST
MAJOR TYPES OF INVESTMENTS
Where Covered
in This Book
Description
Examples
Short-term
investments
Savings instruments with lives
of 1 year or less. Used to
warehouse idle funds and to
provide liquidity.
Deposit accounts, U.S. Treasury
bills (T-bills), Certificates of deposit (CDs), Commercial paper,
Money market mutual funds
Common
stock
Equity investments that represent
ownership in a corporation.
Fixed-income
securities
Investments that make fixed cash
payments at regular intervals.
Bonds, Convertible securities
Preferred stock
Chs. 10, 11
Web Ch. 16
Mutual funds
Companies that pool money
from many investors and invest
funds in a diversified portfolio
of securities.
Large-cap funds, Growth funds
Ch. 12
Exchangetraded
funds
Investment funds, typically index
funds, that are exchange listed
and, therefore, exchange traded.
Stock index funds, Bond
index funds
Ch. 12
Hedge funds
Alternative investments, usually in pools of underlying
securities, available only to
sophisticated investors, such
as institutions and individuals
with significant assets.
Long and short equities, Funds
of funds
Ch. 12
Derivative
securities
Securities that are neither debt
nor equity but are structured
to exhibit the characteristics
of the underlying assets from
which they derive their value.
Options
Futures
Ch. 14
Ch. 15
Other
popular
investments
Various other investments that
are widely used by investors.
Tax-advantaged investments
Real estate
Tangibles
Web Ch. 17
Web Ch. 18
Web Ch. 18
¯˚˘˚˙
Type
Ch. 1
Chs. 6–9
The return on common stock comes from two sources: dividends and capital gains.
Dividends are payments the corporation makes to its shareholders. Companies are not
required to pay dividends, and most firms that are small or are growing very rapidly
do not pay dividends. As firms grow and accumulate cash, they often start paying dividends, just as Hawaiian Airlines did in 2017. Companies that pay dividends usually
pay them quarterly. Capital gains occur when the stock price rises above an investor’s
initial purchase price. Capital gains may be realized or unrealized. If you sell a stock
for more than you paid for it, you have realized a capital gain. If you continue to hold
the stock rather than sell it, you have an unrealized capital gain.
Example
McDonald’s
Common
Stock Return
MyLab Finance
Solution Video
Suppose you purchased a single share of McDonald’s common stock for $119.62
on January 3, 2017, the first day that the stock market was open for trading that
year. During 2017 you received $3.83 in cash dividends. At the end of the year, you
sold the stock for $172.12. You earned $3.83 in dividends and you realized a $52.50
capital gain ($172.12 sale price − $119.62 purchase price) for a total dollar return of
$56.33. On a percentage basis, the return on McDonald’s shares in 2017 is calculated
as $56.33 , $119.62 = 0.471 or 47.1%. If you continued to hold the stock rather
than sell it, you would have earned the same return, but your capital gain would
have been unrealized.
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43
As mentioned earlier, since 1900 the average annual rate of return on common
stocks has been about 11.5%, so 2017 was a good year for McDonald’s. As a fast food
producer, McDonald’s stock generally performs better when the economy is growing
(as it was in 2017) and consumers are more willing to pay for food at restaurants
rather than eating at home.
Fixed-Income Securities
Fixed-income securities are investments that offer a periodic cash payment that may be
fixed in dollar terms or may vary according to a predetermined formula (for example,
the formula might dictate that cash payments rise if a general rise in market interest
rates occurs). Some offer contractually guaranteed returns, meaning that the issuer of
the security (i.e., the borrower) must fulfill a promise to make payments to investors
or risk being sued. Other fixed-income securities come with the expectation of regular
payments even if a contractual obligation is absent. Because of their relatively predictable cash payments, fixed-income securities tend to be popular during periods of
economic uncertainty when investors are reluctant to invest in riskier securities such
as common stocks. Fixed-income securities are also attractive during periods of high
interest rates when investors seek to “lock in” high returns, especially if interest rates
are above the inflation rate. The most common fixed-income securities are bonds, convertible securities, and preferred stock.
Bonds Bonds are long-term debt instruments issued by corporations and governments. A bondholder has a contractual right to receive periodic interest payments plus
return of the bond’s principal, face value, or par value (the original loan amount) at
maturity.
If you purchased a bond with a $1,000 par value paying 6% interest in semiannual installments, you would receive an interest payment equal to +1,000 *
6, * ½ year = +30 every six months. At maturity you would also receive the
bond’s $1,000 face value. Bonds vary a great deal in terms of liquidity, so they may or
may not be easy to sell prior to maturity.
Since 1900 the average annual rate of return on long-term government bonds has
been about 5.3%. Corporate bonds are riskier because they are not backed by the full
faith and credit of the U.S. government and, therefore, tend to offer slightly higher returns than government bonds provide.
Convertible Securities A convertible security is a special type of fixed-income investment. It has a feature permitting the investor to convert it into a specified number of shares of common stock. Convertibles provide the fixed-income benefit of
a bond (interest) while offering the price-appreciation (capital gain) potential of
common stock.
Preferred Stock Like common stock, preferred stock represents an ownership interest
in a corporation and has no maturity date. Unlike common stock, preferred stock has a
fixed dividend payment (in either dollar or percentage terms), and preferred stockholders often have no voting rights. Firms are generally required to pay dividends on preferred shares before they pay dividends on their common shares. Furthermore, if a firm
is having financial difficulties and decides to stop paying preferred dividends, it may
have to make up all of the dividend payments that it skipped before paying dividends
on common shares. Investors typically purchase preferred stocks for the dividends they
pay, but preferred shares may also provide capital gains.
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Mutual Funds
A mutual fund is a portfolio of stocks, bonds, or other assets purchased with a pool
of funds contributed by many different investors and managed by an investment company on behalf of its clients. In addition to mutual funds, investment compaINVESTOR FACTS
nies operate similar investment vehicles such exchange-traded funds (ETFs).
Investors in a mutual fund or an ETF own an interest in the fund’s collecThe Feeling’s Mutual! In 2017, the
16,818 funds managed by investtion of securities. Most individual investors who own stocks do so indirectly
ment companies in the United
by purchasing mutual funds that hold stocks. When they send money to a
States accounted for investment
mutual fund, investors buy shares in the fund (as opposed to shares in the
assets of $22 trillion. These mutual
companies in which the fund invests), and the price of the mutual fund’s
funds and ETFs held 31% of all U.S.
shares reflects the value of the assets that the fund holds. Mutual funds allow
stocks and managed 24% of all
household financial assets.
investors to construct well-diversified portfolios without having to invest a
(Source: 2018 Investment Company
large sum of money. After all, it’s cheaper to buy shares in a fund that holds
Fact Book, downloaded from http://
500 stocks than it is to buy shares in 500 companies on your own. In the
www.icifactbook.org/, accessed
last three decades, the mutual fund industry has experienced tremendous
may 9, 2018)
growth. The number of equity mutual funds (i.e., funds that invest mainly or
exclusively in common stock) has more than quadrupled since 1980.
Most mutual fund managers follow one of two broad approaches when selecting
specific securities for their funds. In an actively managed fund, managers try to identify and purchase securities that are undervalued and are therefore likely to perform
particularly well in the future. Or managers try to identify overvalued securities that
may perform poorly and avoid those investments. The goal of an actively managed
fund is to earn a higher return than some sort of benchmark. For a mutual fund that
invests in stocks, a common goal is to earn a return that is higher than the return on
a market index like the Standard & Poor’s 500 Stock Index (S&P 500). In a passively
managed fund, managers make no attempt to identify under- or overvalued securities.
Instead, they buy a diversified portfolio of stocks and try to mimic or match the return
on a market index. Because these funds provide returns that are close to the returns
on a market index, they are called index funds. For more than a decade, index funds
have been growing, meaning that they have been attracting new dollars from investors,
while actively managed funds have been shrinking as investors withdraw dollars from
those funds to invest in passively managed funds.
In return for the services they provide, mutual funds (or rather, the investment
companies that run the mutual funds) charge investors fees, and some of those fees
are rolled together in a figure known as the expense ratio. The expense ratio is a fee
charged to investors based on a percentage of the assets invested in a fund. It accrues
daily and represents one of the primary costs that investors pay when they purchase
mutual fund shares. For example, if an individual has $10,000 invested in a mutual
fund with an expense ratio of 1%, then the fund will charge $100 per year to manage
the individual’s money.
Expense ratios are generally higher for funds that invest in riskier securities. For
example, in 2017 the average expense ratio among mutual funds investing in stocks
was 0.59%, meaning that investors would pay expenses equal to $59 per $10,000
invested. For funds that invest in bonds, the average expense ratio was 0.48%. Money
market mutual funds (also called money funds) are mutual funds that invest solely in
short-term investments. The average expense ratio for money market mutual funds in
2017 was just 0.25%.
Expense ratios also tend to be higher for actively managed funds. That shouldn’t
be surprising because actively managed funds are more expensive to operate. In 2017,
the average expense ratio for equity index funds was 0.09%, just one-ninth of the average expense ratio for actively managed equity funds (0.78%). For many years, expense
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45
ratios have been declining, a trend that is partly driven by the growing popularity of
passively managed funds. The average expense ratio for equity mutual funds fell 27
basis points (or just over one quarter of one percent) in the last decade, from 0.86% in
2007 to 0.59% in 2017. Falling expense ratios is good news for mutual fund investors.
Even so, there is considerable variation in expense ratios from one fund to another, so
investors need to pay close attention to expenses before they choose a fund.
In addition to the expense ratio, some funds charge a fee called a load. A load may
be charged up front when the investor initially buys shares in the fund, in which case
it is called a sales load. Alternatively, when investors sell their shares the fund may
charge a fee known as a redemption fee or back-end load. Typically, redemption fees
are reduced or waived entirely if investors keep their money in the fund for a long time.
Exchange-Traded Funds
Like mutual funds, exchange-traded funds (ETFs) hold portfolios of securities, and
investors buy shares in the ETF. ETFs are very similar to mutual funds. They allow
investors to form well-diversified portfolios with low initial investments, and the fees
charged by ETFs are generally quite low. However, there are some important differences between ETFs and mutual funds. The main distinction is that ETFs trade on
exchanges, so investors can buy and sell an ETF at its current market price any time
during regular trading hours. Mutual fund shares are not traded on exchanges, and
when an investor buys (or sells) shares in a fund from an investment company, the
transaction occurs at the end of the day using the fund’s closing price, which is determined by adding up the values of the securities the fund holds at the end of the day
and dividing by the number of shares in the fund. If stock prices are changing rapidly
during the day, ETF investors may be able to take advantage of this by purchasing or
selling their shares before prices hit their peak (or bottom). Investors in mutual funds
have to wait until the day’s end to learn the price at which they can trade fund shares.
Another important difference has to do with what happens to the money when investors buy or sell shares. When investors buy shares in a mutual fund, the fund has more
money than it had before, so the fund’s managers will likely use those funds to buy more
securities. Similarly, if investors sell shares in the fund, the fund’s managers may have to
sell securities to raise the cash needed to redeem shares. If many investors want to sell
their shares simultaneously, that may trigger a fire sale—the fund manager has to accept
lower prices to quickly convert the fund’s assets into cash. In contrast, ETF shares represent a fixed number of claims on a fixed portfolio. When investors buy ETF shares, they
are simply acquiring them from other investors who want to sell their shares. There is no
inflow or outflow of cash into the company that manages the ETF, and therefore there is
no need to buy or sell additional securities in response to investors’ transactions.
Launched in 1993, the first ETF was a broad-based equity fund designed to
track the Standard & Poor’s 500 Stock Index. Since then, both the number of ETFs
and the amount of money invested in them has grown explosively. From 2007 to 2017,
the number of ETFs grew 200%, and assets invested in those funds grew at an average
rate of 19% per year. Even so, today there is about 5.5 times more money invested in
mutual funds than in ETFs.
Hedge Funds
Like mutual funds, hedge funds buy securities with pooled money obtained from
many different investors. Hedge funds are generally open to a narrower group
of investors than are mutual funds. For example, the minimum investment required by a mutual fund might be a few hundred dollars, whereas the minimum
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investment required to participate in a hedge fund runs into the hundreds of thousands of dollars. Despite the high minimum investment, hedge funds have grown
in importance in recent years, with assets under management of approximately
$3.5 trillion in 2018.
Hedge funds generally charge much higher fees than do mutual funds. Traditionally,
hedge fund fees follow the “two and twenty” rule, which means that investors pay
annual fees equal to 2% of the assets invested plus 20% of any gains the fund can
achieve. The first component of the fee is the management fee and is independent of
the fund’s performance. The second component is the incentive fee. Investors do not
pay incentive fees if a hedge fund earns a negative return in a particular year, and it
is common for the incentive fee to have a “high-water mark” feature. The high-water
mark specifies that the incentive fee is not payable until a hedge fund passes its previous peak value. For example, if a hedge fund loses 6% in one year and earns 10%
the following year, the incentive fee will not be paid on the second year’s entire 10%
return. Instead, the fee will only apply to the increase in fund value above and beyond
its previous peak. The fund has to earn back the 6% that it previously lost before new
incentive fees kick in.
Hedge funds are not as closely regulated as are mutual funds, and they tend to invest in riskier and less liquid securities. The very name “hedge fund” suggests that these
funds try to limit or hedge the risks that they take, and some hedge funds do operate
with that goal in mind. However, other funds adopt very high-risk investment strategies. Nonetheless, the hedge-fund industry has experienced dramatic growth.
Derivative Securities
As the name suggests, derivative securities derive their value from an underlying security or asset. Many derivatives are among the most risky financial assets because they
are designed to magnify price changes of the underlying asset. For example, when the
price of oil moves up or down by $1 per barrel, the value of an oil futures contract (an
agreement between two parties to trade oil on a future date at a specified price) moves
$1,000 in the same direction. Investors may buy or sell derivatives to speculate on the
movements of the underlying asset, but corporations also buy and sell derivatives to
hedge against some of the risks they face. For instance, a cereal company may purchase
wheat futures contracts as a kind of insurance against the possibility that wheat prices
will rise.
Options Options are securities that give the investor an opportunity to buy or sell an
underlying asset at a specified price for a limited time. The underlying asset is usually
another security such as a share of common stock. Investors may trade stock options to
speculate on a change in the price the underlying common stock. However, the buyer
of a stock option is not guaranteed a return and could easily lose the entire amount
invested if the underlying stock moves in the wrong direction. Two common types of
options are calls and puts. Call options grant the right to buy and put options grant the
right to sell an underlying asset at a fixed price.
Futures Futures are legally binding contracts stipulating that the seller will make delivery and the buyer will take delivery of an asset at a specific date and price. The
underlying asset for a futures contract may be a commodity such as soybeans, pork
bellies, platinum, or oil, or the underlying asset may be a financial instrument such as a
foreign currency or a Treasury bond or even a stock index. Trading in commodity and
financial futures is generally a highly specialized, high-risk proposition.
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Other Popular Investments
Because the U.S. federal income tax rate for an individual can be as high as 37%, many
investors look for tax-advantaged investments that provide higher after-tax returns by
reducing the taxes investors must pay. For instance, municipal bonds, which are issued
by state and local governments, make interest payments that are not subject to federal
income taxation. Because investors do not have to pay taxes on the interest they receive
on municipal bonds, they will accept lower interest rates on these investments than
they will on similar bonds that make taxable interest payments.
Real estate consists of assets such as residential homes, raw land, and a variety
of forms of income property, including warehouses, office and apartment buildings,
and condominiums. The appeal of real estate investment is the potential returns in the
forms of rental income, tax write-offs, and capital gains.
Tangibles are investment assets, other than real estate, that can be seen or touched.
They include gold and other precious metals, gemstones, and collectibles such as coins,
stamps, artwork, and antiques. People purchase these assets as investments in anticipation of price increases.
CONCEPTS
IN REVIEW
1.9
What are short-term investments? How do they provide liquidity?
1.10 What is common stock, and what are its two sources of potential return?
Answers available at
http://www.pearson.com/mylab/
finance
1.11 Briefly define and differentiate among the following investments. Which offer
fixed returns? Which are derivative securities? Which offer professional investment
management?
a. Bonds
b. Convertible securities
c. Preferred stock
d. Mutual funds
e. Hedge funds
f. Options
g. Futures
Making Your Investment Plan
Investing can be conducted on a strictly intuitive basis or on the basis of plans carefully developed to achieve specific goals. Evidence favors the planned approach.
Developing a well-thought-out investment plan encourages you to follow a disciplined approach to managing money. That discipline will help you avoid many common mistakes by keeping you focused on your goals during market swings. A good
investment plan is a reminder of the goals that you are trying to achieve with your
money, and it provides a kind of strategic roadmap to guide investment decisions over
a lifetime. We suggest that your investment plan should begin with an Investment
Policy Statement.
Writing an Investment Policy Statement
Large corporations typically have an investment policy statement (IPS) that spells
out how the corporation will invest funds in the company retirement plan. Financial
advisors write them for their clients. Our view is that an IPS is equally important
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for individual investors like you. Writing such a statement forces you to think carefully about all aspects of your investment plan, a particularly useful exercise for a
novice investor. If you have a spouse or partner, an IPS can help you work out (in
advance) disagreements about how much money the two of you will save and how
that money will be invested. In middle age, an IPS helps you assess the progress
toward your long-term financial goals. Below we outline the major elements of a
well-crafted IPS.
Summarize your current situation. In the opening section of the IPS, list the as-
sets that you own. Set a target for how much money you can save and invest each
month. Describe where the money that you plan to invest will come from. Given
your income and your current spending habits, is it reasonable to expect that you
will have surplus funds to invest? What tax rate do you face today, and how do you
expect that to change in the future? Establish some broad guidelines for the initial
asset allocation in your portfolio. What percentage of your funds do you want to
invest in stocks, bonds, and other investments? Ask yourself how much money you
think you can afford to lose, both in the short term (over a few months) and the
long term (over a few years), and articulate your action plan when losses occur.
Will you sell some of your investments, simply hold onto them, or continue making
new investments each month according to the plan? Try to define your investment
horizon. Will you need to access the funds you are investing in a year, in a decade,
or at the end of your working life? If you plan to enlist the help of a professional
investment advisor, describe the process that you will use to select that person. If
you have already selected an advisor, list that person’s contact information in your
IPS and discuss the statement with him or her, perhaps even getting his or her signature on the document.
Specify your investment goals. Once you have outlined your current situation, write
out your investment goals. Investment goals are the financial objectives you wish to
achieve by investing. Are you trying to reach a specific target savings goal, such as accumulating enough money to make a down payment on a house? Or do you have a
goal that is further out in the future, such as saving enough money to send your children to college or to provide enough income for your own retirement? Is your investment goal to generate more cash flow in the form of interest or dividends, or are you
trying to shelter income from taxation? Achieving each of these goals may call for a
different strategy. For each goal that you specify, try to determine how many years you
will need to save and invest to achieve that goal, and how much money you need to
invest each year to reach your goal.
Articulate your investment philosophy. In this part of the IPS, you’ll want to spell
out your investment philosophy, your views about the types of investments you’re
willing to make, how often you are willing to adjust your portfolio through trading, and other matters that will shape your portfolio. Perhaps the most important
aspect of your investment philosophy is your risk tolerance. Your investment philosophy should indicate how much volatility in the value of your portfolio that you
are willing to tolerate. For example, you might say that your portfolio should be
designed to minimize the chance of losing more than 20% in a year. Your policy
should indicate how important diversification is to you and how many types of
investments you plan to own. Your philosophy will specify the investments you are
not willing to purchase. Perhaps you will choose not to invest in certain industries
for ethical reasons, or you will declare that only “plain vanilla” investments like
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49
stocks and bonds should be part of your portfolio (no derivatives or exotic investments, please). If you are working with a financial advisor, you may specify how
frequently you will change the portfolio by trading, or you may provide guidelines
about the trading costs or (in the case of mutual funds and ETFs) the management
fees you’re willing to pay. In this section of the IPS you may choose to articulate
your assumptions about the returns that you expect different types of investments
to earn.
NOTE Watch Your
Behavior boxes provide
insights about common
mistakes that investors
make gleaned from
research in the field of
behavioral finance.
Set investment selection guidelines. For each type of investment, or asset class,
that you expect to hold (e.g., stocks, bonds, mutual funds), establish guidelines
for how specific investments in that asset class will be selected. For example, if
you plan to hold mutual funds, will you invest in actively or passively managed
funds? In your selection process, how much importance will you place on a fund’s
track record (i.e., its past performance or the experience and education of the fund
manager) and how much on its expense ratio and other costs of investing in the
fund? If you plan to invest directly in stocks, will you focus on large, well-known
companies, or are you more interested in emerging high-tech companies? Does it
matter to you whether the stocks you buy pay dividends? When you are deciding
which bonds to purchase, will you focus more heavily on the creditworthiness of
the bond issuer or on other features of the bond such as its maturity or
the interest rate that it offers?
WATCH YOUR BEHAVIOR
Watch Your Investments, But Not
Too Closely Researchers have
uncovered an interesting aspect
of investor behavior. Individuals
who monitor their portfolios less
frequently tend to invest more in
risky assets. Almost by definition,
risky investments will frequently
experience periods of low or even
negative returns, even though over
long periods of time risky assets
tend to earn higher returns than
safe assets do. When investors
check their portfolios frequently,
they apparently find it uncomfortable to observe the periods when
risky investments perform badly,
so they simply take less risk. One
study found that when a new law
in Israel prevented retirement
funds from displaying returns for
any period shorter than 12 months,
investors put more of their money
in riskier assets. In the long run,
taking very little risk leads to very
low returns, so it is not clear that
watching investments too closely
is a good thing.
Assign responsibility for selecting and monitoring investments. In this
(Source: Based on “The Display of
Information and Household Investment
Behavior,” Finance and Economics
Discussion Series 2017-043, Board
of Governors of the Federal Reserve
System.)
should consider both federal and state and local taxes. The federal income
tax is the major form of personal taxation. Since the Tax Cuts and Jobs
Act of 2017, federal tax rates range from 10% to 37%, although tax rates
will rise again in 2026 unless Congress acts to extend those tax cuts into
the future.
part of the IPS, you indicate whether you will make your own investment
selections or enlist the help of an advisor. Likewise, you establish a plan
for monitoring your investments. Do you plan to evaluate your investment
performance quarterly, semiannually, or just once a year?
What criteria will you use to determine whether your investments are
meeting your expectations? Any risky investment is bound to have periods
when it performs poorly, so your IPS should provide some guidance about
how long you are willing to tolerate subpar performance before making a
change in the portfolio. Similarly, an investment that performs particularly
well for a year or two will inevitably account for a rising fraction of the
portfolio’s overall value. Your IPS may describe the conditions under which
you might sell some of your better performing investments simply to rebalance the portfolio.
Considering Personal Taxes
Knowledge of the tax laws can help you reduce taxes and increase the aftertax dollars you have for investing. Because tax laws are complicated and
subject to frequent revision, we present only the key concepts and how they
apply to investment transactions.
Basic Sources of Taxation When forming your investment plans, you
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State and local taxes vary widely. Top earners in California face a tax rate of
13.3%, and eight other states have tax rates on high-income households that range
from 8% to 9.9%. Some cities, especially large East Coast cities, also have local income taxes that typically range between 1% and 4%. In addition to income taxes,
state and local governments rely heavily on sales and property taxes as a source of
revenue.
Income taxes at the federal, state, and local levels have a great impact on investment returns. Property taxes can have a sizable impact on real estate and other forms
of property investment.
Types of Income The income of individuals is classified into three basic categories:
• Active income consists of everything from wages and salaries to bonuses, tips,
and pension income. Active income is made up of income earned on the job as
well as most other forms of noninvestment income.
• Portfolio income includes earnings generated from various types of investments.
This category covers most (but not all) types of investments from savings accounts, stocks, bonds, and mutual funds to options and futures. For the most
part, portfolio income consists of interest, dividends, and capital gains (the
profit on the sale of an investment).
• Passive income is a special category of income composed chiefly of income derived from real estate, limited partnerships, and other forms of tax-advantaged
investments.
Ordinary Income Whether it’s classified as active, portfolio, or passive, ordinary
income is taxed at the federal level at one of seven rates: 10%, 12%, 22%, 24%,
32%, 35%, or 37%. There is one tax-rate structure for taxpayers who file individual
returns and another for those who file joint returns with a spouse. Table 1.2 shows
the 2018 tax rates and income brackets for these two categories. Note that the rates
are progressive; that is, income is taxed in a tiered progression—the first portion of a
taxpayer’s income is taxed at one rate, the next portion at a higher rate, and so on.
Under a progressive tax structure, an investor’s marginal tax rate, the tax rate paid
on the last dollar of income, may be different than the average tax rate, the ratio of
total taxes due to total taxable income. An example demonstrates ordinary income
taxation.
TABLE 1.2
FEDERAL INCOME TAX RATES AND BRACKETS FOR INDIVIDUAL AND JOINT
RETURNS (DUE BY APRIL 15, 2019)
Taxable Income
Tax Rates
Individual Returns
Joint Returns
10%
$0 to $9,525
$0 to $19,050
12%
$9,526 to $38,700
$19,051 to $77,400
22%
$38,701 to $82,500
$77,401 to $165,000
24%
$82,501 to $157,500
$165,001 to $315,000
32%
$157,501 to $200,000
$315,001 to $400,000
35%
$200,001 to $500,000
$400,001 to $600,000
37%
Over $500,000
Over $600,000
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Consider the Ellis sisters, Joni and Cara. Both are single. Joni’s taxable income is
$50,000. Cara’s is $100,000. Using the tax rates and income brackets in Table 1.2, we
can calculate their taxes as follows:
Example
Tax Liabilities,
Average Tax, and
Marginal Tax
MyLab Finance
Solution Video
NOTE This icon
indicates that there is a
downloadable Excel file
available on myLab
Finance that matches the
text’s content at the point
where the icon appears.
Joni:
0.10 * $9,525 + 0.12 * 1$38,700 - $9,525 2 + 0.22 * 1$50,000 - $38,700 2
= $952.50 + $3,501 + $2,486 = $6,939.50
Cara:
0.10 * $9,525 + 0.12 * 1$38,700 - $9,525 2 + 0.22 * 1$82,500 - $38,700 2
+ 0.24 * 1$100,000 - $82,500 2 = $952.50 + $3,501 + $9,636 + $4,200
= $18,289.50
Notice that Joni pays about 13.9% of her income in taxes ($6,939.50 , $50,000)
while Cara’s taxes amount to 18.3% of her income ($18,289.50 , $100,000). The progressive nature of the federal income tax structure means that Cara pays a higher
fraction of her income in taxes—although her taxable income is twice Joni’s, Cara’s
income tax is about 2.6 times Joni’s. Because Cara’s income is higher than Joni’s, she
faces a higher marginal tax rate. Cara’s last dollar of income is taxed at a 24% rate,
whereas Joni’s last dollar is taxed at just 22%. You can build a spreadsheet model like
the one below to automate these calculations, so you can calculate the tax bill for an
individual taxpayer with any income level.
X
A
MyLab
B
C
D
1
2
3
F
G
Individual Returns
Tax Rates
4 (% of income)
5
6
7
8
9
10
11
12
13
14
15
16
17
E
TAX RATES, INCOME BRACKETS, AND INCOME TAX FOR
INDIVIDUAL RETURNS (2018)
10%
Taxable Income
$0 to $9,525
(Marginal rate 3 amount over base
Base Tax 1 bracket)
$0.00 1 (10% 3 amount over $0)
12%
$9,526 to $38,700
$952.50 1 (12% 3 amount over $9,525)
22%
$38,701 to $82,500
$4,453.50 1 (22% 3 amount over $38,700)
24%
32%
$82,501 to $157,000
$157,001 to $200,000
$14,089.50 1 (24% 3 amount over $82,500)
$32,089.50 1 (32% 3 amount over $157,000)
35%
$200,001 to $500,000
$45,689.50 1 (35% 3 amount over $200,000)
37%
Over $500,000
$150,689.50 1 (37% 3 amount over $500,000)
Joni’s Income
$50,000
Joni’s Income Tax
$6,939.50
Cara’s Income
$100,000
Joni’s Income Tax
$18,289.50
Capital Gains and Losses A capital asset is property owned and used by the taxpayer for
personal reasons, pleasure, or investment. The most common types are securities and real
estate, including one’s home. A capital gain represents the amount by which the proceeds
from the sale of a capital asset exceed its original purchase price. Under current tax law,
several tax rates apply to capital gains income depending on the length of the investment
holding period and the taxpayer’s income. For assets held more than 12 months, the tax
law classifies capital gains as long term and taxes them at rates ranging from 0% for
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TABLE 1.3
FEDERAL INCOME LONG-TERM CAPITAL GAINS TAX RATES AND BRACKETS
FOR INDIVIDUAL AND JOINT RETURNS (DUE BY APRIL 15, 2019)
Taxable Income
Tax Rates
Individual Returns
Joint Returns
0%
$0 to $38,600
$0 to $77,200
15%
$38,601 to $425,800
$77,201 to $479,000
20%
Over $425,800
Over $479,000
low-income taxpayers to 23.8% for high-income earners. For assets held less than 12
months, the law classifies capital gains as short term and taxes them at the ordinary income
rates in Table 1.2. Table 1.3 shows the 2018 tax brackets and rates that apply to long-term
capital gains for single taxpayers and married taxpayers filing a joint return. For single
taxpayers earning more than $200,000 (or married taxpayers earning more than $250,000),
an additional 3.8% tax on investment income applies, bringing the top tax rate on longterm capital gains to 23.8%.
Example
Capital Gains
and Total Tax
MyLab Finance
Solution Video
Imagine that James McFail, a single person who has other taxable income totalling $75,000, sold 500 shares of stock at $12 per share. He purchased this stock at
$10 per share. The total capital gain on this transaction was $1,000 [500 shares *
($12>share - $10>share)]. James’s taxable income totals $76,000, and he is in the 22%
tax bracket (seeTable 1.2).
If James held the asset for more than 12 months, based on his income he would
have to pay a 15% tax on the $1,000 capital gain. His total tax would be calculated as
follows:
Ordinary income ($75,000)
0.10 * $9,525 + 0.12 * 1$38,700 - $9,525 2
+ 0.22 * 1$75,000 - $38,700 2 = $952.50 + $3,501 + $7,986 = $12,439.50
Capital gain ($1,000)
0.15 * $1,000 = $150
Total tax
$12,439.50 + $150 = $12,589.50
James’s total tax would be $12,589.50. Had his other taxable income been below
$38,600, James would have owed no tax on the capital gain. Had James held the
asset for fewer than 12 months, his $1,000 capital gain would have been taxed as
ordinary income, which in James’s case would result in a 22% rate.
Capital gains are appealing because investors do not pay taxes on those gains until
they are realized. For example, if an investor purchased stock for $50 that at the end of
the tax year has a market price of $60, the investor has a “paper gain” of $10. This paper
(unrealized) gain is not taxable because the investor still owns the stock. Only realized
gains are taxed. If the investor sold the stock for $60 per share during the tax year, he
would have a realized—and therefore taxable—gain of $10 per share.
A capital loss results when a capital asset is worth less than its original purchase
price. Like gains, capital losses may be realized or unrealized, but only realized losses have
tax consequences. Before calculating taxes, investors net out all capital gains and losses.
CHAPTER 1
WATCH YOUR BEHAVIOR
Cut Your Taxes and Your Losses
Several researchers have found
that investors are very reluctant to
sell stocks that have gone down in
value, presumably because they
hope to “get even” in the future.
Holding losers rather than selling
them is often a mistake because
the tax code provides an incentive
to sell these stocks. Investors can
deduct realized investment losses
(up to a point) against other forms
of income, thereby lowering their
tax liabilities.
I
THE INVESTmENT ENVIRONmENT
53
Taxpayers can apply up to $3,000 of net losses against ordinary income in any
year. Losses that cannot be applied in the current year may be carried forward
and used to offset future income, subject to certain conditions.
Investments and Taxes The opportunities created by the tax laws make tax
planning important to investors. Tax planning involves looking at earnings,
both current and projected, and developing strategies that will defer and
minimize taxes. The tax plan should guide investment activities to achieve
maximum after-tax returns (for an acceptable risk level) over the long run.
Because investors do not pay capital gains taxes until realizing gains,
they can control the timing of capital gains taxes. However, investments
that are likely to produce the largest capital gains generally have higher
risk than those that provide significant current income. Therefore, investors should not choose investments solely on tax considerations. Instead
they must strike a balance of tax benefits, investment returns, and risk. It
is the after-tax return and associated risk that matter.
Tax-Advantaged Retirement Savings Plans The federal government has established a
number of plans that offer special tax incentives designed to encourage people to save
for retirement. Those that are employer sponsored include profit-sharing plans, thrift and
savings plans, and 401(k) plans. These plans allow employees to defer paying taxes on
funds that they save and invest during their working years until they withdraw those funds
during retirement. Individuals who are self-employed can set up their own tax-sheltered
retirement programs such as Keogh plans and SEP-IRAs. Other savings plans with tax
advantages are not tied directly to the employer. Almost anyone can set up an individual
retirement arrangement (IRA), although the law limits the tax benefits of these plans for
high-income taxpayers. In a traditional IRA, investors do not pay taxes on contributions to
the plan or on investment earnings generated on those contributions until they withdraw
funds during retirement. In a Roth IRA, contributions are taxed up front, but subsequent
investment earnings and withdrawals are tax-free. For most people, these plans offer an
attractive way to both accumulate funds for retirement and reduce taxes.
Investing over the Life Cycle
NOTE An Advisor’s
Perspective boxes consist
of short video clips of
professional investment
advisors who share their
practical insights about
the material covered in
this text.
Investors tend to follow different investment philosophies as they move through different stages of life. Most tend to be more aggressive when they’re young and more conservative as they grow older. Typically, investors move through these investment stages:
AN ADVISOR’S PERSPECTIVE
Rick Loek, CEO,
Calrima Financial and
Insurance Agency
“There are three financial phases
that we go through in life.”
MyLab Finance
Growth-oriented
youth
(age: 20 to 45)
Middle-age
consolidation
(age: 46 to 60)
Income-oriented
retirement years
(age: 61 to ?)
Most investors in their twenties and thirties prefer high-risk, growthoriented investments that stress capital gains rather than current income.
Young investors can tolerate more risk because their investment horizon is
longer, and they have more time to make adjustments to their savings objectives if their portfolios suffer large losses. For these reasons, portfolios of
young investors often heavily weight common stocks, particularly smaller
companies and firms in fast-growing industries.
As investors approach middle age, family demands and responsibilities
such as educational expenses and retirement contributions become more important. The whole portfolio often shifts to a less aggressive posture. Stocks
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that offer a balance between growth and income—high-grade bonds, preferred stocks,
convertibles, and mutual funds—are all widely used at this stage.
Finally, when investors approach their retirement years, preservation of capital
and current income become the principal concerns. A secure, high income stream is
paramount. Investors place less emphasis on growing their portfolio. Instead, they
structure their portfolios to generate regular cash flow with relatively low exposure to
risk. The investment portfolio now becomes highly conservative. It consists of low-risk
income stocks and mutual funds, government bonds, quality corporate bonds, bank
certificates of deposit (CDs), and other short-term investments. At this stage, investors
reap the rewards of a lifetime of saving and investing.
Investing over the Business Cycle
The returns on common stocks and other equity-related securities (convertible securities,
stock mutual funds, stock options, and stock index futures) respond sharply to macroeconomic conditions. The business cycle refers to the recurring sequence of growth and
decline, boom and recession that characterizes all economies. The business cycle reflects
the current status of economic variables such as gross domestic product (GDP), industrial production, personal disposable income, the unemployment rate, and more.
An expanding business cycle reflects a strong economy. Stocks tend to be a leading
indicator of the business cycle, meaning that stock prices often rise prior to periods when
business is good and profits are up. Growth-oriented and speculative stocks tend to do especially well in strong markets. To a lesser extent, so do low-risk and income-oriented stocks.
In contrast, stock values often fall several months before periods when economic activity is
declining. The reason that stocks move ahead of the business cycle is that stock prices reflect
investors’ beliefs about companies’ future prospects. When investors believe that business
conditions will deteriorate, stock prices fall even before those poor business conditions materialize. Of course, the same thing happens in reverse when investors believe the economy
will perform better. Stock prices rise in anticipation of strong future economic performance.
Panel A of Table 1.4 confirms this pattern. The table shows that over the past 15 recessions, covering the period from 1926 to 2018, the average monthly return on the stock
market was lower in the six months leading up to a recession (-0.26% per month) than it
was during the recession (0.37%). The table also shows that on average the stock market
performs very well (1.75% per month) in the first 12 months after a recession ends.
Returns on bonds and other forms of fixed-income securities (bond funds and preferred stocks) also respond to the business cycle because they are highly sensitive to
interest-rate movements. In fact, no factor has more to do with changing bond prices and
returns than changes in interest rates. Interest rates and bond prices move in opposite
directions (Chapters 10 and 11). Therefore, rising interest rates reduce the returns on
bonds already held in an investor’s portfolio. Of course, high interest rates enhance the attractiveness of new bonds because these bonds must offer high returns to attract investors.
If you had a crystal ball and could foresee the future, our advice to you would be to
load up on high-risk investments each time the economy was nearing the end of a recession and to discard those investments in favor of safer assets near the end
WATCH YOUR BEHAVIOR
of each economic boom. Of course, no one has such a crystal ball, and unfortunately professional economic forecasters and investment professionals
James Grant, Founder,
Grant’s Interest Rate
do not have a particularly strong record at predicting turns in the economy
Observer
and financial markets. Panel B of Table 1.4 illustrates that even if you knew
when recessions would start and end, there would still be a high degree of
“The biggest mistake we investors
uncertainty about the returns you could earn by moving in and out of the
make is being human.”
stock market around recessions. For example, during the most recent recesMyLab Finance
sion (2007 to 2009), stocks lost 34.46% of their value, so having perfect
CHAPTER 1
TABLE 1.4
I
THE INVESTmENT ENVIRONmENT
55
PERFORMANCE OF STOCKS BEFORE, DURING, AND AFTER RECESSIONS
Panel A
Average Monthly Return (%)
6 Months Prior to
Recession
During Recession
12 Months After
Recession
- 0.26
0.37
1.75
Panel B
Total Return (%)
Dates of Prior Recessions
October 1926 to November 1927
August 1929 to March 1933
18.01
33.41
41.66
9.27
- 76.29
96.77
- 0.03
- 25.08
100.30
February 1945 to October 1945
9.95
22.80
- 4.85
November 1948 to October 1949
5.32
5.06
28.45
May 1937 to June 1938
July 1953 to May 1954
August 1957 to April 1958
- 5.27
26.73
36.31
9.31
- 6.58
39.73
April 1960 to February 1961
- 0.54
19.42
13.08
December 1969 to November 1970
- 8.46
- 7.51
12.95
November 1973 to March 1975
4.49
- 20.23
28.52
January 1980 to July 1980
9.75
16.18
15.65
July 1981 to November 1982
1.15
12.67
25.74
July 1990 to March 1991
1.84
7.09
13.72
- 20.60
- 6.92
- 14.89
- 2.04
- 34.46
16.45
March 2001 to November 2001
December 2007 to June 2009
NOTE Famous Failures
in Finance boxes highlight
important problems that
sometimes occur in the
investments field. These
problems may deal with
ethical lapses, as in the
box below, or they may
involve various kinds of
failures that take place in
the marketplace.
foresight about that event and avoiding the stock market during that period would have
paid off. But notice that the stock market gained value in eight of the past 15 recessions!
In other words, even if you knew when a recession would start and end, you wouldn’t
know whether it would be wise to stay invested in stocks or to get out.
Perhaps the best advice that we can offer regarding investments and the business
cycle is this: Do not overreact to the ups and downs that appear to be an unavoidable (and unpredictable) part of economic life. Investors who load up on risky assets
after the market has already risen from its bottom and who dump their stocks after
the market has begun a slide will probably perform worse than investors who apply a
consistent investment strategy over many years through many business cycles.
FAMOUS
FAILURES Ethical Failure—Massaging the Numbers
Greenberg of American International Group (AIG),
IN FINANCE In recent years, business head-
lines were full of allegations of
massive financial fraud committed by prominent business
leaders. These allegations shocked the investment
community and resulted in spectacular bankruptcies of large corporations. Civil and criminal charges
against the key executives involved in the fraud soon
followed. Among the list of business leaders charged
or convicted of financial fraud were Bernie Madoff,
Ramalinga Raju of Satyam Computer Services, Hank
and David Glenn of Freddie Mac.
In many cases, the primary weapon of fraudulent
CEOs was the use of corporate accounting to report
huge, fictitious profits or hide financial problems. To
cite just one example, prior to its 2008 bankruptcy,
the investment banking firm Lehman Brothers had
repeatedly engaged in a transaction known as Repo
105. In this transaction, just before it issued a quarterly financial report, Lehman Brothers essentially
borrowed money on a short-term basis (usually
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for 7 to 10 days) from another entity. However, on
Lehman’s balance sheet that loan was recorded as
an asset sale. On Lehman’s publicly released financial statements, this transaction made it appear that
Lehman Brothers had more cash and less debt than
it actually did. More than 16 years after the passage
of the Sarbanes-Oxley Act, legislation designed to
CONCEPTS
IN REVIEW
prevent this kind of corporate fraud, investors have
learned the hard way that corporate fraud is a significant risk that remains difficult to anticipate or detect
until it is too late.
Critical Thinking Question Why do you think
Lehman engaged in Repo 105 transactions?
1.12 What should an investor establish before developing and executing an investment
program? Briefly describe the elements of an investment policy statement.
Answers available at
http://www.pearson.com/mylab/
finance
1.13 Define and differentiate among the following. Explain how each is related to federal
income taxes.
a. Active income
b. Portfolio and passive income
c. Capital gain
d. Capital loss
e. Tax planning
f. Tax-advantaged retirement investments
1.14 Describe the differing investment philosophies typically applied during each of the
following stages of an investor’s life cycle.
a. Youth (ages 20 to 45)
b. Middle age (ages 46 to 60)
c. Retirement years (age 61 and older)
1.15 Discuss the relation between stock prices and the business cycle.
Meeting Liquidity Needs with Short-Term Investments
Liquidity is the ability to convert an investment into cash quickly with little or no loss
in value. A checking account is highly liquid. Stocks and bonds are a little less liquid
because there is no assurance that you will be able to quickly sell them without having
to cut the price to attract a buyer and because selling these securities usually triggers
various transactions costs. Real estate is even less liquid and may take weeks or months
to sell even if you are willing to accept a very low price. Unexpected life events such as
illness and unemployment sometimes require individuals to draw on their savings to
meet daily expenses, so planning for and providing for adequate liquidity is an important part of an investment plan.
The Role of Short-Term Investments
Short-term investments represent an important part of most savings and investment
programs. They generate income, although with the prevailing near-zero interest rates
in recent years, the income provided by these investments has been quite low. However,
their primary function is to provide a pool of reserves for emergencies or simply to accumulate funds for some specific purpose. As a rule of thumb, financial planners often
suggest that individuals hold cash reserves equivalent to three to six months of their
after-tax salary, and typically they would invest this type of emergency fund in safe,
liquid, short-term investments.
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57
Some individuals choose to hold short-term investments because they simply do not
want to take the risk inherent in many types of long-term investments. Certainly there
are periods when these low-risk investments perform better than stocks and bonds.
Regardless of the motives for holding short-term investments, investors should evaluate them in terms of their risk and return, just as they would longer-term investments.
FAMOUS
FAILURES A Run for the Money
IN FINANCE During the Great Depression,
individuals became fearful
about the ability of banks to
survive, and this prompted
a great number of bank runs. One of these featured prominently in Frank Capra’s classic film It’s
A Wonderful Life. In a bank run many of a bank’s
depositors attempt to withdraw money from their
accounts at the same time. Because the bank holds
only a small fraction of its deposits as cash in a
vault, a run can cause a bank to run out of cash
quickly and fail as a result. In fact, thousands of
banks failed in the 1930s for this reason. To protect
banks against runs, the U.S. government created
a deposit insurance program via the Banking Act
of 1933, which guaranteed that each depositor’s
money (up to $2,500) would be returned to him or
her in the event of a bank failure. This led to fewer
bank runs and fewer bank failures. In 1934 only nine
banks failed, compared with more than 9,000 from
1929 to 1933.
AN ADVISOR’S PERSPECTIVE
James Grant, Founder,
Grant’s Interest Rate
Observer
“Low rates present many difficulties
to the wary and the unwary.”
MyLab Finance
Just a decade ago, during the financial crisis, depositors began to question the safety of banks and
other financial institutions not only in the United
States but also in many other countries. In an attempt to reassure depositors and to prevent a classic
bank run, several countries increased the limit on
their deposit insurance programs. In 2008 the Federal
Deposit Insurance Corporation (FDIC) increased
the amount of insured deposits from $100,000 to
$250,000. Greece, Poland, Sweden, Denmark, and
the United Kingdom all increased their limits on insured deposits. In Greece and Ireland the limit was
entirely eliminated, committing those governments
to cover 100% of customers’ deposits at insured financial institutions. As part of the Dodd-Frank Wall
Street Reform and Consumer Protection Act, the
FDIC announced in 2010 that it would temporarily
provide unlimited insurance for non-interest-bearing
accounts at all FDIC-insured institutions. Today the
deposit insurance limit is $250,000 per depositor at
each bank.
Interest on Short-Term Investments Short-term investments earn interest
in one of two ways. Some investments, such as savings accounts, pay a
stated rate of interest, which, as the name implies, is just the stated rate
on the account.
Alternatively, some short-term investments earn interest on a discount basis. This means that investors buy the security at a price below
its redemption value (or face value), and the difference between what they
pay to acquire the asset and what they receive when it matures is the interest the investment will earn. U.S. Treasury bills (T-bills), for example, are
issued on a discount basis.
Risk Characteristics Short-term investments are generally not very risky. Their primary risk results from inflation risk—the potential loss of purchasing power that may
occur if the rate of return on these investments is less than the inflation rate. Investors
holding money in bank savings accounts have experienced this outcome regularly in recent years. The average interest rate on bank money market savings accounts has been
below 0.5% since 2010, but over that same period, the average annual inflation rate
has been about 1.7%. Usually, short-term investments provide rates of return that are
slightly higher than the inflation rate, but actions by the U.S. Federal Reserve have kept
short-term interest rates at historically low levels since the last recession.
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The risk of default—nonpayment—is almost nonexistent with short-term investments. The reason is that issuers of most short-term investments are highly reputable
institutions, such as the U.S. Treasury, large banks, and major corporations. In addition, government agencies insure deposits in commercial banks, savings and loans,
savings banks, and credit unions for up to $250,000 per account. Finally, because the
value of short-term investments does not change much in response to changing interest
rates, exposure to capital loss is correspondingly low.
Advantages and Disadvantages of Short-Term Investments As noted, the major
advantages of short-term investments are their high liquidity and low risk. Most are
available from local financial institutions and are easy to convert to cash. Finally, because the returns on short-term investments usually vary with inflation and market
interest rates, investors can readily capture higher returns as rates move up. On the
negative side, when interest rates go down, returns drop as well. Perhaps their biggest
disadvantage is their relatively low return. Because these securities are generally so low
in risk, the returns on short-term investments average less than the returns on longterm investments.
Common Short-Term Investments
Individual investors have access to a variety of short-term investments. Some are
deposit-type accounts where investors can place money, earn a relatively low rate
of interest, and conveniently withdraw funds at their discretion. Part A of Table 1.5
summarizes the common deposit-type accounts. The federal government also issues
TABLE 1.5
COMMON SHORT-TERM INVESTMENTS
Part A. Deposit-Type Accounts
Type of Account
Description
Minimum Balance
Interest Rate
Federal Insurance
Passbook savings
account
Savings accounts offered by banks.* Used
primarily for convenience or if investors
lack sufficient funds to
purchase other shortterm investments.
Typically none
0.25%–4% depending
on economy
Up to $250,000 per
deposit.
Negotiable order of
withdrawal (NOW)
account
Bank checking account
that pays interest on
balances.
No legal minimum,
but often set at
$500 to $1,000
At or near passbook
rates
Up to $250,000 per
deposit.
Money market
deposit account
(MMDA)
Bank deposit account
with limited checkwriting privileges.
No legal minimum,
but often set at
about $2,500
Typically slightly
above passbook rate
Up to $250,000 per
deposit.
Asset management
account
Deposit account at bank,
brokerage house,
mutual fund, or insurance company that
combines checking,
investing, and borrowing. Automatically
“sweeps” excess
balances into shortterm investments
and borrows to meet
shortages.
Typically $5,000 to
$20,000
Similar to MMDAs
Up to $250,000 per
deposit in banks.
Varies in other
institutions.
CHAPTER 1
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59
Part B. Federal Government Issues
Security
Issuer
Description
Initial Maturity
Risk and Return
I bonds
U.S. Treasury
Savings bonds issued by the U.S.
Treasury in denominations as low as
$25; earn an interest rate that varies
with the inflation
rate; interest is
exempt from state
and local taxes.
30 years, but redeemable after 1 year
Lowest, virtually risk
free
Treasury bills
U.S. Treasury
Issued weekly at
auction; sold at a
discount; strong
secondary market;
exempt from local
and state income
taxes.
1 year or less
Lowest, virtually risk
free
Part C. Nongovernment Issues
Security
Issuer
Description
Initial Maturity
Risk and Return
Certificates of deposit
(CDs)
Commercial banks
Cash deposits in
commercial banks;
amounts and maturities tailored to
investor’s needs.
1 month and longer
Higher than U.S.
Treasury issues
and comparable to
commercial paper
Commercial paper
Corporation with a high
credit standing
Unsecured note
of issuer; large
denominations.
3 to 270 days
Higher than U.S.
Treasury issues
and comparable
to CDs
Banker’s acceptances
Banks
Analogous to a postdated check on
an account with
overdraft protection; a time draft
drawn on a customer’s account,
guaranteed by a
bank; bank’s “acceptance” makes
the trade a tradable
instrument.
30 to 180 days
About the same
as CDs and commercial paper but
higher than U.S.
Treasury issues
Money market mutual funds (money
funds)
Professional portfolio management
companies
Professionally managed portfolios of
marketable securities; provide instant
liquidity.
None—depends on
wishes of investor
Vary, but generally
higher than U.S.
Treasury issues
and comparable to
CDs and commercial paper
* The term bank refers to commercial banks, savings and loans (S&Ls), savings banks, and credit unions.
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short-term investments. Part B of Table 1.5 summarizes basic features of many of those
instruments. The final group of short-term investments includes nongovernment instruments, typically issued by a financial institution or a corporation. Part C of Table 1.5
summarizes these investments.
Investment Suitability
Individual investors use short-term investments for both savings and investment. When
the savings motive is paramount, investors use these assets to maintain a desired level
of savings that will be available if the need arises—in essence, to provide safety and
security. For this purpose, an investment’s return is less important than its safety, liquidity, and convenience. Passbook savings accounts and NOW (negotiable order of
withdrawal) accounts are examples of short-term investments that fulfill investors’
short-term savings needs.
When investors use short-term securities for investment purposes, the return that
these instruments provide is often just as important as their liquidity. Most investors
will hold at least a part of their portfolio in short-term, highly liquid securities, if for
no other reason than to be able to act on unanticipated investment opportunities. Some
investors, in fact, devote all or most of their portfolios to such securities.
Investors also use short-term securities as a temporary place to “park” funds before deciding where to invest the money on a long-term basis. An investor who just
sold some stock but does not have a suitable long-term investment alternative might
place the proceeds in a money fund until he or she finds a longer-term use for them.
Investors buying short-term securities for this warehousing function prefer the securities offering the highest returns—like money market deposit accounts (MMDAs), CDs,
commercial paper, banker’s acceptances, and money funds.
To decide which securities are most appropriate for a particular situation, investors need to consider such characteristics as availability, safety, liquidity, and rate of
return. Although all investments we have discussed satisfy the basic liquidity demand,
they do so to varying degrees. A NOW account, which is an interest-earning deposit
account on which an investor may write an unlimited number of checks, is unquestionably the most liquid of all. A certificate of deposit, on the other hand, is not so
liquid because early redemption involves an interest penalty. Table 1.6 summarizes
TABLE 1.6
A SCORECARD FOR SHORT-TERM INVESTMENT
Type of Investment
Availability
Safety
Liquidity
Typical Rate
in 2018
NOW account
A-
A+
A+
0.20%
Passbook savings account
A+
A+
A
0.40%
Money market mutual fund (money fund)
B
A/A+
B+
1.75%
Money market deposit account (MMDA)
B
A+
A
1.25%
Asset management account
B-
A
A+
0.50%
U.S. Treasury bill (1 year)
B-
A+ +
A-
2.10%
Banker’s acceptance (90 day)
B-
A
B
1.75%
Commercial paper (90 day)
B-
A-
B-
2.00%
Certificate of deposit (1 year, large
denomination)
B
A{
B
2.04%
I bonds
A+
A+ +
C-
2.50%
CHAPTER 1
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61
the key characteristics of the short-term investments described in Table 1.5. The letter
grade assigned for each characteristic reflects an estimate of the investment’s quality in
that area. For example, money market mutual funds (money funds) rate only a B+ on
liquidity because withdrawals must usually be made in a minimum amount of $250
to $500. NOW accounts are somewhat better in this respect because a withdrawal
can be for any amount. Rates on short-term investments tend to be low. Among the
investments listed in Table 1.6, the rates on NOW and passbook savings accounts are
typically lowest, and the rates on I bonds are the highest. In 2018 rates on all of these
instruments were low by historical standards. For example, a large, 1-year CD offered
investors a return of 2%. You should note, though, that if an investment scores lower
on availability, safety, or liquidity, it will generally offer a higher rate.
CONCEPTS
IN REVIEW
Answers available at
http://www.pearson.com/mylab/
finance
1.16 What makes an asset liquid? Why hold liquid assets? Would 100 shares of IBM stock
be considered a liquid investment? Explain.
1.17 Explain the characteristics of short-term investments with respect to purchasing
power and default risk.
1.18 Briefly describe the key features and differences among the following deposit
accounts.
a. Passbook savings account
b. NOW account
c. Money market deposit account
d. Asset management account
1.19 Define, compare, and contrast the following short-term investments.
a. I bonds
b. U.S. Treasury bills
c. Certificates of deposit
d. Commercial paper
e. Banker’s acceptances
f. Money market mutual funds (money funds)
Careers in Finance
Regardless of the job title, a career in finance requires an understanding of the
investment environment. The principles presented in this text will provide an initial
foundation in investments essential to pursuing one of the many rewarding career
paths. Well-prepared and enthusiastic students have access to a wide variety of job
opportunities. Many people who pursue a career in the investments field obtain one
of two professional certifications: Certified Financial Planner (CFP®) or
Chartered Financial Analyst (CFA). Each of these certifications can help
AN ADVISOR’S PERSPECTIVE
advance a career, although the requirements and the focus of each certification are somewhat different.
Bryan Sweet, Founder
and CEO, Sweet
The CFP® program is primarily designed for people who want to work
Financial Services
directly with clients, helping them develop and execute investment plans.
Obtaining the CFP® credential requires a bachelor’s degree in finance or
“The CFP gives you confidence when
a related field and a passing grade on the six-hour CFP® Certification
speaking to clients.”
Exam, which in 2018 had a pass rate of 64%. The exam focuses heavily
MyLab Finance
on aspects of the advisor–client relationship including establishing and
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defining client relationships, analyzing a client’s current financial position, and developing, communicating, implementing, and monitoring investment recommendations.
In addition to passing the exam, earning the CFP® requires three years of professional
work experience in financial planning and a commitment to abide by a code of ethics
established by the CFP® Board. People with the CFP® credential typically work as financial advisors, either in their own practice or as part of a larger team.
The CFA program’s focus is more appropriate for people who want to work as institutional investors, for example as a financial analyst on Wall Street. CFAs must pass
a series of three grueling six-hour exams (Level 1, Level 2, and Level 3), each of which
usually requires hundreds of hours of study. Typically the pass rate on these exams is
50% or less. Examples of CFA exam questions appear scattered throughout this text
and on MyLab Finance. Prospective CFAs also need a bachelor’s degree (in any field)
simply to register for the exam. In addition, they must have four years of qualified investment work experience, and they must adhere to the CFA Institute’s Code of Ethics
and Professional Conduct. The most common job held by CFAs is portfolio manager,
but people with this certification also work as consultants, financial analysts inside
corporations, traders, risk managers, and more.
With or without any of these professional credentials, there are many career opportunities open to those who are well trained in investments. Some of the industries with
investments-oriented career opportunities are commercial banking, corporate finance,
financial planning, insurance, investment banking, and investment management.
Commercial Banking Commercial banks provide banking services to individuals and
businesses alike. In spite of considerable consolidation within the banking sector, more
people work in commercial banking than in any other area of the financial services
industry.
Due to the vast range of services they provide, commercial banks offer a tremendous variety of career opportunities, many of which require investments training.
Commercial banks offer jobs such as mortgage lender, mortgage underwriter, corporate lender, asset manager, leasing, consumer credit or trade credit analyst, and portfolio manager.
Corporate Finance Corporations offer several rewarding job opportunities for those
with investments expertise. Corporations require financial professionals to manage
cash and short-term investments, raise and manage long-term financing, evaluate and
undertake investments, and interface with investors and the financial community.
The top finance job in a corporation is that of the chief financial officer (CFO).
The CFO manages the firm’s capital resources and capital investments. Investment
principles are important to CFOs because so much of a CFO’s job revolves around
communication with investors. A CFO must understand how investors view the firm
and value the securities the firm has issued. A CFO’s job (and most other corporate
finance jobs) is typically focused on increasing a firm’s value through successful business decisions. More so than other finance-related jobs, corporate finance jobs require
a broad understanding of the various functional areas within the corporate setting
(e.g., operations, marketing, and accounting) and how these areas contribute to the
corporate finance goals.
Financial Planning A financial planner counsels clients on how to establish and
achieve their short- and long-term financial goals. Personal financial planners provide
financial advice relating to education, retirement, investment, insurance, tax, and estate planning. Business owners consult them for advice on issues such as cash flow
CHAPTER 1
WATCH YOUR BEHAVIOR
Misguided Advisors Critics of the
financial advising industry have long
argued that conflicts of interest lead
advisors to give more guidance to
their clients, for example by persuading them to invest in high-cost,
actively managed mutual funds
rather than in low-cost index funds.
New research suggests that these
advisors follow their own advice
when they invest their own money,
putting too much in costly funds,
diversifying too little, and chasing
returns. The study concludes that
financial planners and stockbrokers
mislead their clients not only because they have a financial incentive to do so but also because they
believe their own bad advice.
(Source: Based on Linnainmaa, Juhani T.,
Brian T. melzer, and Alessandro
Previtero, The misguided Beliefs of
Financial Advisors, Journal of Finance,
forthcoming.)
I
THE INVESTmENT ENVIRONmENT
63
management, investment planning, risk management and insurance planning, tax planning, and business succession planning.
An ability to clarify objectives, assess risks, and develop strategic plans
is essential for financial planners. For example, if a client desires to send
a child to college someday, what savings or investment strategies are best
suited to meet that client’s goals? Financial planners can work within a
large financial services company such as ING, within a small practice, or
for themselves.
Insurance The insurance business is a trillion-dollar industry that serves
both individual and business clients. There are two prominent finance jobs
in insurance. The first involves providing individuals or businesses with
products that provide cash payments when unfavorable events (e.g., sickness, death, property damage due to fire or natural disaster) occur, and the
second involves investing the premiums that customers pay when they buy
insurance. Individuals and businesses purchase insurance products in order
to protect themselves from catastrophic losses or to guarantee certain outcomes. Insurers collect premiums and fees for the services they provide and
they invest those funds in assets so that when customers submit claims,
the insurance company will have the cash to fulfill the financial promises
they made to their customers. In 2018 the U.S. insurance industry managed roughly $7 trillion in assets, and it employed large numbers of highly
trained investment specialists.
Investment Banking Investment banks help firms and governments raise money by
issuing stocks and bonds, and they facilitate trading activities of both institutional and
retail investors by making markets. Their in-house security analysts provide research
on both equity and fixed-income securities, and they provide financial advice to and
manage financial assets for high net worth individuals, firms, institutions, and governments. Investment banks even provide their clients with quantitative analysis or program trading and consultation on mergers and acquisitions.
The investment banking industry changed dramatically during the 2008 financial
crisis. Many investment banks invested heavily in securities tied to U.S. real estate
values, and when home prices began to drop, the losses on banks’ investments began
to mount. Several prominent investment banks either went bankrupt or were acquired
by other banks. Since then, the industry has recovered to a degree, but there are fewer
professionals working in investment banks today than there were a decade ago.
Investment Management As the name implies, investment management is all about
managing money for clients. The role of an investment manager includes elements of
financial analysis, asset selection, security (e.g., stock or bond) selection, and investment implementation and monitoring. Most investment management is done on behalf
of a pool of investors whose investments comprise a fund. Some common examples of
managed funds are bank trust funds, pension funds, mutual funds, exchange-traded
funds, and hedge funds.
Money managers often specialize in managing a portfolio of a particular type of security. Some money managers buy and hold fixed-income securities, including mortgagebacked securities, corporate bonds, municipal bonds, agency securities, and asset-backed
securities. Others focus on equities, including small stocks, large caps, and emerging market stocks. Some managers invest only in domestic securities, while others buy securities
in markets all over the world. As noted earlier in this chapter, passively managed funds
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TABLE 1.7
AVERAGE SALARIES FOR VARIOUS FINANCE JOBS (2018)
Job Title
Salary
Years of Experience
Commercial Banking
Commercial credit analyst, Jr.
$ 47,392
0
Commercial credit analyst, Sr.
$ 92,616
7
Lending officer, Jr.
$ 86,801
8
Lending officer, Sr.
$ 160,611
12
Financial analyst, Jr.
$ 55,693
0
Financial analyst, Sr.
$100,312
7
Assistant controller
$125,222
7
Investor relations director
$163,324
10
Treasurer
$195,014
7
Chief financial officer
$361,258
15
Analyst
$ 77,000
0
Associate
$130,000
3
Managing director
$834,000
18
Corporate Finance
Investment Banking
Investment Management
Securities analyst
$114,663
2
Investment specialist
$100,406
2
Portfolio manager
$109,495
5
Investment operations manager
$133,464
7
(Sources: Data from Salary.com; data for investment banking from https://news.efinancial
careers.com/uk-en/185046/much-earn-now-investment-banker-30s
(i.e., those that make no attempt to identify and invest in undervalued securities) have
been gaining market share at the expense of actively managed funds for at least a decade.
Table 1.7 lists average salaries and required years of experience for a variety of
jobs in the commercial banking, corporate finance, investment banking, and investment management fields. Many of these jobs have an investments focus, but not all do.
Keep in mind that there is substantial variation around these averages. Larger firms
and firms in areas with higher costs of living tend to pay more. For entry-level positions, an individual’s salary might be higher or lower than the average reported here
based on the candidate’s undergraduate major, grade point average, extracurricular
activities, or simply how they handle a job interview. Salaries reported in Table 1.7
also do not include bonuses, which can be considerable in certain industries (such as
investment banking). Bonuses tend to account for a larger fraction of total pay in jobs
that require more experience. Still, the table conveys the idea that job opportunities in
finance are quite attractive.
Developing Skills for Your Career
A basic knowledge of investments is useful to almost anyone regardless of their chosen career path. Professionals from every field have to make investment decisions
with their own money such as how much to save, what types of assets to invest in, or
CHAPTER 1
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65
whether to invest following active or passive strategies. Fortunately, the skills needed
to make good investment decisions are applicable to business decisions in general, and
therefore they can help you land and succeed in a job even if you are not working in the
investments field (or in a finance job). Below we highlight skills you can develop while
working through this book.
Critical Thinking For many people working in a business, it is not obvious how dayto-day decisions drive a firm’s stock price up and down. The stock price is one measure
of a firm’s success, so the same factors that investors think about in determining what
a stock is worth are important to managers running the firm that issued the stock. In
this text, we emphasize that good investment decisions balance risk and return, and
that is true of most business decisions as well. A critical evaluation of any proposed
course of action requires an analysis of the risks of that action as well as its potential
rewards. Virtually every chapter in this text provides guidance about how to make
critical judgments regarding either the risks or the rewards (or both) tied to investment
decisions. By mastering those chapters you will learn how to apply criteria that lead to
better decisions. You will learn the assumptions behind and the key relationships driving financial models, so even if your job does not involve building those models, you
can help shape them by providing the data and analysis that the financial analysts at
your firm use to provide financial justifications for key decisions. Your understanding
of financial principles will also help you to identify weaknesses in financial analysis
which, left uncorrected, might lead to suboptimal decisions.
Communication and Collaboration In most large businesses today, employees work
in cross-functional teams. If your aim is to work in marketing or supply chain or even
general management, rest assured that working with a colleague from the finance department will be part of your regular routine. Thus, you need to understand how financial people think and the vocabulary they use to communicate with them effectively
and persuasively. Developing a basic financial proficiency will help you gather and
organize the information that the financial analyst on your team needs to demonstrate
the value of your team’s work to the larger organization.
Financial Computing Skills Though an in-depth discussion of using Excel or other
computer programs to build complex financial models is beyond the scope of this text,
some of the Excel tools that see widespread practice in financial modeling are introduced. Even if your job does not involve building models in Excel, financial analysts in
your firm will routinely present their analysis in that form, and your ability to respond
and contribute to that analysis hinges upon your understanding of at least the basics
of those models. Remember that finance is often the gatekeeper of corporate funds, so
gaining support from the finance department may be an important step in marshaling
the resources you need to do your job effectively. It’s easier to gain that support if you
are conversant in the basics of financial modeling in Excel.
CONCEPTS
IN REVIEW
Answers available at
http://www.pearson.com/mylab/
finance
1.20 Why is an understanding of investment principles important to a senior manager
working in corporate finance?
1.21 Why do insurance companies need employees with advanced training in investments?
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MyLab Finance
Here is what you should know after reading this chapter. Mylab Finance
will help you identify what you know and where to go when you need to
practice.
What You Should Know
Key Terms
NOTE The end-of-chapter summaries
restate the chapter’s Learning Goals
and review the key points of information related to each goal.
NOTE A list of Key Terms gathers in one place the new vocabulary presented in each chapter.
Where to Practice
Understand the meaning of the
term investment and list the attributes that distinguish one investment
from another. An investment is any
asset into which investors can place
funds with the expectation of generating positive income and/or increasing
their value. The returns from investing
are received either as income or as increased value.
Some of the attributes that distinguish one type of investment from another include whether the investment
is a security or property; direct or indirect; debt, equity, or derivative; low
risk or high risk; short term or long
term; and domestic or foreign.
debt, p. 38
derivative securities, p. 38
direct investment, p. 37
domestic investments, p. 39
equity, p. 38
foreign investments, p. 39
indirect investment, p. 37
investment, p. 36
liquidity, p. 36
long-term investments, p. 39
portfolio, p. 36
property, p. 36
returns, p. 36
risk, p. 38
securities, p. 36
short-term investments, p. 39
MyLab Finance
Study Plan 1.1
Describe the investment process
and types of investors. Financial
institutions and financial markets bring
together suppliers and demanders of
funds. The dominant U.S. financial market is the securities market for stocks,
bonds, and other securities. The participants in the investment process are government, business, and individuals. Only
individuals are net suppliers of funds.
Investors can be either individual investors or institutional investors.
diversification, p. 38
financial institutions, p. 39
financial markets, p. 39
individual investors, p. 40
institutional investors, p. 40
MyLab Finance
Study Plan 1.2
Discuss the principal types of investments. Short-term investments
have low risk. They are used to earn a
return on temporarily idle funds, to serve
as a primary investment for conservative
investors, and to provide liquidity.
Common stocks offer dividends and
capital gains. Fixed-income securities—
bonds, convertible securities, and preferred stock—offer fixed periodic returns
with some potential for gain in value.
Mutual funds allow investors to buy or
sell interests in a professionally managed,
diversified group of securities. Exchangetraded funds are similar to mutual funds
except that they can be bought and sold
bonds, p. 43
capital gains, p. 42
common stock, p. 41
convertible security, p. 43
dividends, p. 42
exchange-traded funds (ETF),
p. 45
fixed-income securities, p. 43
futures, p. 46
hedge funds, p. 45
money funds, p. 44
money market mutual funds, p. 44
MyLab Finance
Study Plan 1.3
CHAPTER 1
I
THE INVESTmENT ENVIRONmENT
What You Should Know
Key Terms
Where to Practice
on an exchange during the trading day.
Hedge funds are also similar to mutual
funds except that they are open only
to relatively wealthy investors, they
tend to make riskier investments, and
they are subject to less regulation than
mutual funds.
Derivative securities such as options
and futures are high-risk investments.
Options offer an opportunity to buy or
sell another security at a specified price
over a given period of time. Futures are
contracts between a seller and a buyer
for delivery of a specified commodity or
financial instrument, at a specified future
date, at an agreed-on price. Other popular investments include tax-advantaged
investments, real estate, and tangibles.
mutual fund, p. 44
options, p. 46
preferred stock, p. 43
real estate, p. 47
tangibles, p. 47
tax-advantaged investments, p. 47
Describe the purpose and content
of an investment policy statement, review fundamental tax considerations, and discuss investing over the
life cycle. Investing should be driven by
well-developed plans established to
achieve specific goals. A good place to
begin an investment plan is to create a
written investment policy statement.
Investors must also consider the tax
consequences associated with various
investments and strategies. The key
dimensions are ordinary income, capital gains and losses, tax planning, and
tax-advantaged retirement plans.
The investments selected are affected by the investor’s stage in the life
cycle and by economic cycles. Younger
investors tend to prefer growthoriented investments that stress capital
gains. As they age, investors move to
less risky securities. As they approach
retirement, they become even more
conservative. Some investments, such
as stocks, behave as leading indicators
of the state of the economy.
capital loss, p. 52
investment goals, p. 48
net losses, p. 53
tax planning, p. 53
MyLab Finance
Study Plan 1.4
Describe the most common types
of short-term investments.
Liquidity needs can be met by investing
in various short-term investments, which
can earn interest at a stated rate or on a
discount basis. They typically have low
risk. Banks, the government, and brokerage firms offer numerous short-term
investments. Their suitability depends on
discount basis, p. 57
MyLab Finance
Study Plan 1.5
67
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What You Should Know
Key Terms
Where to Practice
the investor’s attitude toward availability, safety, liquidity, and rate of return.
MyLab Finance
Study Plan 1.6
Describe some of the main careers
available to people with financial
expertise and the role that investments
play in each. Exciting and rewarding career opportunities in finance are available in many fields, such as commercial
banking, corporate finance, financial
planning, insurance, investment banking, and money management.
Log into MyLab Finance, take a chapter test, and get a personalized Study Plan
that tells you which concepts you understand and which ones you need to
review. From there, MyLab Finance will give you further practice, tutorials,
animations, videos, and guided solutions.
Log into www.pearson.com/mylab/finance
Discussion Questions
NOTE The Discussion
Questions at the end of
the chapter ask you to
analyze and synthesize
information presented in
the text. These questions,
like all other end-ofchapter assignment
materials, are keyed
to the chapter’s
learning goals.
Q1.1
Assume that you are 35 years old, are married with two young children, are renting a
condo, and have an annual income of $100,000. Use the following questions to guide
your preparation of a rough investment plan consistent with these facts.
a. What are your key investment goals?
b. How might personal taxes affect your investment plans? Use current tax rates to
assess their impact.
c. How might your stage in the life cycle affect the types of risks you might take?
Q1.2
What role, if any, will short-term investments play in your portfolio? Why? Complete the
following table for the short-term investments listed. Find their current yields online, and
explain which, if any, you would include in your investment portfolio.
Type of Investment
Minimum Balance
a. Passbook savings account
None
b. NOW account
d. Asset management account
f. U.S. Treasury bill
g. Certificate of deposit (CD)
h. Commercial paper
i. Banker’s acceptance
j. Money market mutual fund
(money fund)
Federal
Insurance
Method and Ease of Withdrawing
Funds
Yes
In person or through teller
machines; very easy
Unlimited check-writing
privileges
c. Money market deposit
account (MMDA)
e. Series I savings bond
Interest
Rate
Virtually none
CHAPTER 1
Problems
THE INVESTmENT ENVIRONmENT
69
Select problems are available in MyLab Finance. The X icon indicates problems in Excel format
MyLab
available in MyLab Finance.
P1.1
Peter Müller, a 40-year-old mechanic, plans to retire at age 65 and wants to accumulate
€500,000 over the next 25 years to supplement the retirement programs provided by
the German government and his employer Volkswagen. He expects to earn an average
annual return of about 8% by investing in a low-risk portfolio containing about 25%
short-term securities, 50% common stock and 25% bonds.
Peter currently has €44,300 that at an 8% annual rate of return will grow to about
€150,000 by his 65th birthday. (The €150,000 figure is found using time value of
money techniques, Chapter 4 appendix.) Peter consults a financial advisor to determine
how much money he should save each year to meet his retirement savings objective. His
advisor tells him that if he saves about €20.95 each year, he will accumulate €1,000 by
age 65. Saving five times that amount each year, €104.75, allows Peter to accumulate
roughly €5,000 by age 65.
a. How much additional money does Peter need to accumulate over time to reach his
goal of €500,000?
b. How much must Peter save to accumulate the sum calculated in part a over the
next 25 years?
P1.2
During 2018, the Smiths and the Joneses both filed joint tax returns. For the tax year
ended December 31, 2018, the Smiths’ taxable income was $130,000, and the Joneses
had total taxable income of $65,000.
a. Using the federal tax rates given in Table 1.2 for married couples filing joint returns, calculate the taxes for both the Smiths and the Joneses.
b. Calculate and compare the ratio of the Smiths’ to the Joneses’ taxable income and
the ratio of the Smiths’ to the Joneses’ taxes. What does this demonstrate about
the federal income tax structure?
P1.3
Greg and Natalie Wang, both in their 50s, have $100,000 to invest and plan to retire in 10
years. They are considering two investments. The first is a utility company common stock
that costs $50 per share and pays dividends of $1 per share per year (a 2% dividend yield).
Note that these dividends will be taxed at the same rates that apply to long-term capital
gains. The Wangs do not expect the value of this stock to increase. The other investment
under consideration is a highly rated corporate bond that currently sells for $1,000 and
pays annual interest at a rate of 2.5%, or $25 per $1,000 invested. After 10 years, these
bonds will be repaid at par, or $1,000 per $1,000 invested. Assume that the Wangs keep the
income from their investments but do not reinvest it (they keep the cash in a non-interestbearing bank account). They will, however, need to pay income taxes on their investment
income. They will sell the stock after 10 years if they buy it. If they buy the bonds, in 10
years they will get back the amount they invested. The Wangs are in the 33% tax bracket.
a. How many shares of the stock can the Wangs buy?
b. How much will they receive after taxes each year in dividend income if they buy
the stock?
c. What is the total amount they would have from their original $100,000 if they
purchased the stock and all went as planned?
d. How much will they receive after taxes each year in interest if they purchase the
bonds?
e. What is the total amount they would have from their original $100,000 if they
purchased the bonds and all went as planned?
f. Based only on your calculations and ignoring other risk factors, should they buy
the stock or the bonds?
NOTE The problems
at the end of the chapter
offer opportunities to
perform calculations using
the tools and techniques
learned in the chapter.
X
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P1.4
Alex Del Piero is a professor at La Sapienza University. The taxable income for salaries
of up to €15,000 is 23%, while interest, dividends (for non-substantial participation),
and capital gains (realized or unrealized) are subject to a 26% tax rate. The tax is not
calculated on a universal income basis. In 2019, he had the following taxable income:
1. €13,000 from salary (ordinary income)
2. €1,000 in interest income
3. €500 in dividend income
4. €200 in capital gains from sale of a stock he purchased a year ago
5. €300 in capital gains from a stock which he still holds
Use the data above to work this problem and answer the following questions:
a. How much will Alex pay in income taxes on item 1 above?
b. How much will Alex pay in income taxes on item 2 above?
c. How much will Alex pay in income taxes on item 3 above?
d. How much will Alex pay in income taxes on items 4 and 5 above?
X
P1.5
Wolfgang and Martha who live in Zurich, Switzerland, have been dating for years and
are now thinking about getting married. As a financially sophisticated couple, they
want to think through the tax implications of their potential union.
a. Suppose that Wolfgang and Marta each earn CHf50,000 a year (so their combined
income is CHf100,000). Using the personal income tax rates available at:
http://taxsummaries.pwc.com/ID/Switzerland-Individual-Taxes-on-personalincome, calculate the total direct federal tax and Zurich cantonal tax they would
pay if they remain single, and compare that to the taxes they would pay if they
were married and filed a joint return.
b. Now suppose that Wolfgang and Marta both earn CHf25,000 (so their combined
income is CHf50,000). Do the same calculations you did in part (a).
c. What differences do you find in parts (a) and (b)? What is the cause of these
differences?
P1.6
Using the individual tax rate schedule shown in Table 1.2, perform the following:
a. Calculate the tax liability, after-tax earnings, and average tax rates for the following levels of partnership earnings before taxes: $10,000; $80,000; $300,000;
$500,000; $1 million; $1.5 million; and $2 million.
b. Plot the average tax rates (measured on the y-axis) against the pretax income levels
(measured on the x-axis). What generalization can be made concerning the relationship between these variables?
MyLab
NOTE Two Case
Problems appear at the
end of every chapter.
They ask you to apply
what you have learned in
the chapter to a
hypothetical investment
situation.
Visit http://www.pearson.com/mylab/finance for web exercises,
spreadsheets, and other online resources.
Case Problem 1.1
Start-up Funding
You plan to start your own company after graduation. Throughout university, you have been
working on a new technology and have done plenty of research for your thesis. In preparation for
graduation, you have already created a detailed business plan. In addition, you have talked to
several potential stakeholders and potential clients and have already designed some prototypes. By
the time you graduate, you manage to sell some prototypes, and you already have a group of clients waiting for an even better prototype. You decide that it is now time to invest in the required
production facilities so that your small business can take off. However, you need financing from
institutions and/or individuals to undertake the required investment. You dig out your business
plan to review it and realize that to present a strong case to convince potential investors, you need
answers to the following questions: