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McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved. 11 Investment Basics and Evaluating Bonds

11-3 Investing Basics 1.Explain why you should establish an investment program 2.Describe how safety, risk, income, growth, and liquidity affect your investment program 3.Identify the factors that reduce investment risk 4.Recognize why investors purchase bonds and other conservative investments. 5.Evaluate bonds when making an investment Chapter Objectives

11-4 Objective 1: Explain why you should establish an investment program Establishing Investment Goals  Financial goals should be specific and measurable. They should be tailored to your financial needs and what you want to accomplish. To develop your goals ask yourself..  What will you use the money for?  How much money do you need for your goals?  How will you obtain the money?  How long will it take you to obtain the money?  How much risk are you willing to assume in an investment program?

11-5 Establishing Investment Goals  What possible economic or personal conditions could alter your investment goals?  Considering your economic circumstances, are your investment goals reasonable?  Are you willing to make the sacrifices necessary to ensure that you meet your investment goals?  What will the consequences be if you don’t reach your investment goals? (continued)

11-6 Performing a Financial Checkup  Work to balance your budget. –Do you regularly spend more than you make?  Pay off high interest credit card debt first.  Obtain adequate insurance protection.  Start an emergency fund you can access quickly. –Three to nine months of living expenses.  Have access to other sources of cash for emergencies. –Line of credit is a short-term loan approved before the money is needed. –Cash advance on your credit card.

11-7 Getting the Money Needed to Start an Investing Program  Pay yourself first.  Take advantage of employer- sponsored retirement programs.  Participate in elective savings programs.  Make a special savings effort one or two months each year.  Take advantage of gifts, inheritances, and windfalls.

11-8 The Value of Long-Term Investing Programs  Many people don’t start investing because they only have a small amount to invest, but even small amounts invested regularly grow over a long period of time.  If you begin savings $2,000 each year (depending on the rate of return, you could have over $1 million by the time you are age 65—See Exhibit  The higher the rate of return the greater the risk.

11-9 Objective 2: Describe how safety, risk, income, growth, and liquidity affect your investment decisions Factors Affecting the Choice of Investments  Safety and risk. –Safety in any investment means minimal risk of loss. –Risk means a measure of uncertainty about the outcome. –Investments range from very safe to very risky. –The potential return on any investment should be directly related to the risk the investor assumes. –Speculative investments are high risk, made by those seeking a large profit in a short time.

11-10 Components of the Risk Factor  Inflation risk - during periods of high inflation your investment return may not keep pace with the inflation rate.  Interest rate risk – the value of bonds or preferred stock may increase or decrease because of changes in interest rates in the economy.  Business failure risk - affects stocks and corporate bonds.  Market risk - prices fluctuate because of behaviors of investors.

11-11 Investment Growth and Liquidity  Income - An investment will provide a predictable source of income.  Growth - means investment will increase in value. –Common stock usually offers the greatest potential for growth. –Mutual funds, government and corporate bonds, and real estate offer growth potential.  Liquidity –Ability to buy or sell an investment quickly without substantially affecting the investment’s value.

11-12 Objective 3: Identify the factors that can reduce investment risk.  Asset allocation is the process of spreading your assets among several different types of investments. Other factors to consider include: –The time factor –Your age –Your role in the investment process

11-13 Government Bonds and Debt Securities  Sold to obtain money to finance the national debt, and the ongoing costs of government.  Three levels of government issue bonds: –Federal. –State. –Local municipalities.

11-14 U.S. Government Treasury Bills and Notes Treasury Bills (T-Bills).  $1,000 minimum.  4, 13, or 26 weeks to maturity.  Sold at a discount.  Federal but no state tax on interest earned. Treasury Notes.  $1,000 units.  Typical maturities are 2, 3, 5, and 10 years.  Interest paid every six months, at a higher rate than T-bills.  Federal but no state tax on interest earned.

11-15 Federal Agency Debt Issues  FHA - Federal Housing Administration  Fannie Mae - Federal National Mortgage Association.  Ginnie Mae - Government National Mortgage Association.  Freddie Mac - Federal Home Loan Mortgage Corporation.  Essentially risk free, and earn slightly higher interest than government securities issued by the treasury department.  Maturities range from 15 – 30 years.  Average maturity is 15 years.

11-16 State and Local Government Securities  Municipal bonds - sometimes called munis.  Issued by a state or local government, including cities, counties, school districts, and special taxing districts.  Use funds for ongoing costs and to build major projects such as schools, airports, and bridges.  General obligation bonds are backed by the state or local government that issues them.  Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge.

11-17 Taxable Equivalent Yield Tax-exempt yield ___________________ Your tax rate Example: 0.06 Taxable equivalent yield = __________ = = 8.3%

11-18 Characteristics of Corporate Bonds  Corporation’s written pledge to repay a specified amount of money with interest.  The face value is the dollar amount that the bondholder will receive at the bond’s maturity date.  Bondholders receive interest payments every six months at the stated interest rate.  The legal conditions are described in a bond indenture.  A trustee is a financially independent firm that acts as the bondholder’s representative.

11-19 Why Corporations Sell Bonds  To get funds for major purchases.  To fund ongoing business activities.  When it is difficult or impossible to sell stock.  To improve financial leverage.  Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay.

11-20 Types of Corporate Bonds  Debenture bond. –Most corporate bonds are debenture bonds. –Unsecured - Backed only by the reputation of the issuing company.  Mortgage bond. –A corporate bond that is secured by various assets of the issuing firm, usually real estate. –Interest rate is lower because it is secured.

11-21 Types of Corporate Bonds  Convertible bond. –A special kind of corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. –Generally, the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds. –Convertible bonds, like all potential investments, must be carefully evaluated. (continued)

11-22 Provisions For Repayment Call Feature of a Bond  Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date.  Most corporate bonds are callable.  Most agree not to call bonds for the first 5 to 10 years after they are issued.  They call bonds if the interest rate they are paying is much higher than the going rate.

11-23 Provisions For Repayment  Sinking fund. –Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due.  Serial bonds. –Bonds of a single issue that mature on different dates. (continued) Bond

11-24 Objective 4: Explain Why Investors Buy Corporate Bonds  For interest income. –Investors know the interest rate. –Interest will be paid to investors twice a year, with the payment based on the interest rate and the face value of the bond.  Dollar appreciation of bond value. –May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the current interest rate.  Bond face amount will be repaid at maturity.

11-25 Objective 5: Evaluate bonds when making an investment decision  The Decision to Buy or Sell a Bond –There are a number of sources of information that can be used to evaluate bond investments. –The internet –Use it for price information, trade bonds online and lastly do research on the issuing corporation and its bond issues  Read the bond quotes in the newspaper.  How is the bond rated? –Rating range from AAA to D. –BB or below is called a junk (speculative) bond. –Rated by Standard and Poors and Moodys, with information on their websites.

11-26 The Decision to Buy or Sell a Bond  Bond Yield Calculations –Current Yield = annual income amount divided by current market value  Other Sources of Information –Business Periodicals –Government Sources