Chapter 2 Investment Alternatives by dffhrtcv3

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Chapter 2: Investment
Alternatives
Bonds

   The par value (face value) of most
bonds is \$1000.
   The bond generally matures
(terminates) on a specified date and it
technically known as a term bond.
   Most bonds are coupon bonds, where
coupon refers to the periodic interest
that the issuer pays to the holder of
bonds.

   A five-year, 5.50 % Government of Canada coupon
bond was listed in the Globe and Mail on May 21,
2004. Assuming the bond has a par value of
\$1000, it has a dollar coupon of \$55.00 (5.5% of
\$1000); therefore, knowing the percentage coupon
rate is the same as knowing the coupon payment in
dollars. If the interest on the bond is paid semi-
annually, this bond would pay interest (the
coupons) of \$27.50 on a specified date every six
months. The \$1000 principal would be repaid five
years hence at the maturity date. (Therefore we
say the term-to-maturity date is five years)
Bonds cont’d…
   By convention, bond prices are quoted as a
proportion of par value using 100 as par
rather than 1000.
   Therefore a price of 90 represents \$900, as
a price of \$55 represents \$550, using the
normal assumption of a par value of \$1000.
   The easiest way to convert quoted bond
prices to actual prices is to remember that
they are quote in percentages, with the
common assumption of a \$1000 par value.
Price of a Government of Canada Bond

   The ask price of the five year 5.5 %
Government of Canada bond was 105.86 on
May 20, 2004. This quoted price represents
105.86 percent of \$1000, or \$1058.60
   This suggests that an investor could
purchase the bond for \$1058.60 on that day.
Bonds cont’d…
   Bonds trade on an accrued interest basis.
Meaning, the bond buyer must pay the bond
seller the price of the bond as well as the
interest that has been earned (accrued) on
the bond since the last interest payment.
   This allows an investor to sell a bond at any
time without losing the interest that has
accrued.
   Bond buyers should remember this
prices are quoted in the paper without the
accrued interest.
Government Bonds
   Government bonds are issued by the government and
are the largest single issuer of bonds within any given
country. These bonds are sold at competitive auctions
and are sold at approximately face value with
investors submitting bids on yields. Within these types
of bonds, interest rates are paid semi-annually and
that the face value of these bonds come in \$1,000,
\$5,000, \$10,000, 100,000, \$500,000 and 1 million.
Unlike other types of bonds, these are considerably
safe in terms of risk and default because of the
government’s ability to print money and increase
taxes to level the value. Many people purchase these
types of bonds with the idea of earning a steady
stream of income and with assurance of receiving par
value when they mature.
Corporate Bonds

   Corporate bonds are usually purchased by
large corporations to help finance their
operations. These types of bonds offer a
wide variety of maturities, coupons and

   Corporate bonds are also referred to as,
‘senior securities’ in the sense that they
offer priority payment on any common or
preferred stocks.
Corporate Bonds cont’d…

   Within the bond category itself there are
various degrees of security.
   Mortgage bonds are secured by real
assets which means that holders have
legal claim to specific assets of the
issuer.
   Debentures are generally unsecured and
are backed only by the issuer’s overall
financial soundness.
ABS – Asset-Backed Securities

   Securitization refers to the transformation of
illiquid, risky individual loans into more
liquid, less risky securities referred to as
asset-backed securities.
   The best example of this process is
mortgage-backed securities (MBS).
   These are created when a financial
institution purchases a number of mortgage
loans that are then repackaged and sold to
investors as mortgage pools.
   Investors in MBSs are in effect, purchasing
a piece of a mortgage pool.
ABS – Asset-Backed Securities cont’d…

   MBS investors assume little default risk because
most mortgages are guaranteed by a federal
government agency.
   The Canada Mortgage and Housing Corporation
(CMHC) introduced MBSs in Canada in 1987. they
issue fully guaranteed securities in support of the
mortgage market.
   These securities have attracted considerable
attention in recent years because the principal and
interest payments on the underlying mortgages
used as collateral are “passed through” to the
bondholder monthly as the mortgages are repaid.
MBS’s cont’d…
   These securities are not completely riskless
because they can receive varying amounts
of monthly payments depending on how
quickly home owners pay off their
mortgages. Although the stated maturity
rate can be as long as 40 years, the
average life of these securities of this life
has actually been much shorter. ABSs are
created when an underwriter, such as a
bank bundles some types of assets linked
debt, and sells investors the right to invest
Marketable Securities cont’d…

   Marketable securities have been backed by
car loans, credit card receivables, small
business loans, leases for photo copiers or
aircraft etc. The assets that can be
securitized seem to be limited only by the
imagination of the packagers. As evidenced
by the fact that new asset types include
items such as student loans, mutual fund
fees, tax liens, monthly hydro bills, and
delinquent child support payments!
Risks of MBS

   As we have seen in 2007 and 2008
investors underestimated the risks
associated many of these investments. The
market value of MBS had fallen to 6.5 trillion
by February of 2008. As a result of the
massive market write downs from the
subprime crisis fallout
   This decline in value occurred despite the
fact that the actual number of low grade
(subprime) mortgages comprising MBSs
was “supposed to be” relatively small.
Risks cont’d…

   Indeed, many investors (mainly
institutional investors – the so-called
“experts”) holding various MBSs and
ABSs experienced severe losses as
the market values of these instruments
declined substantially.
Equity Securities
   Equity securities represent an ownership in a
corporation.
   Preferred Stock – a hybrid security that is part
equity and part fixed-income security because it
increases in value but also pays a dividend.
   P/S rank below creditors but above common
shareholders in terms of priority of payment of
income and in case of liquidation.
   While payment of preferred dividends is not
obligatory like interest payments, payment to
common s/h has to wait until preferred s/h receive
full payment of the dividends to which they are
entitled.
Preferred Share cont’d
   Most preferred shares are non-voting; however,
once a stated number of dividend payments have
been omitted, it is common practice to assign
voting privileges to the preferred.
   P/S usually have a “cumulative” feature
associated with their dividends. This requires the
firm to pay all preferred dividends (both current
and arrears) before paying any dividends to
common s/h, and that make p/s less risky than c/s
from the investor’s point of view.
Income Trusts
   Income Trusts: investment instruments that
pay out a substantial portion of cash flows
generated from the underlying revenue-
generating assets.
   Two of the more recognizable forms being
royalty trusts and real estate investments
trusts (REITs).
   Technically, the trust owns the underlying
assets and investors purchase units in the
trust, which entitles them to a certain
(substantial) portion of the cash flows
generated by the underlying assets.
Income Trusts Cont’d
   The income trust structure is attractive because it
generates tax savings at the business level since it
minimizes or eliminates taxes at the corporate level,
thus reducing (or avoiding) the double taxation of
income that would have been distributed by a
similar tax paying corporation.
   This tax avoidance is possible because income
trusts are permitted to treat part (or all) of the
investment in the equity of the operating company
as debt for tax purposes.
   As a result, they can classify the payments to trust
unit holders as an interest expense, which reduces
(or eliminates) taxable income.
Income Trusts Cont’d

   This is different from dividend
which are not tax deductible and are
   As a result, income trusts are able to
offer investors a higher cash flow yield
that would otherwise be possible;
hence the attractiveness to investors.
Common Stock
   Represents the ownership interest of
corporations or the equity of the
shareholders.
   If a firms shares are owned by only a few
individuals, the firm is said to be closely
held.
   Most companies choose to go public, or
they sell common stock to the general
public, primarily to let them raise additional
capital more easily.
Common Stock Continued

   As the residual claimants of the
corporations, shareholders are entitled to
income remaining after the fixed income
claimants such as the preferred
shareholders have been paid; also, in case
of liquidation of the corporation, they are
entitled to the remaining assets after all
other claims (including preferred stock) are
satisfied.
Common Stock

   As owners, the holders of common
stock are entitled to elect the directors
of the corporation and vote on major
issues.
   Each shareholder is allowed to cast
votes equal to the number of shares
owned when such votes take place.
Common Stock
   There often exists a clause in a corporations’
charter that grants existing shareholders the first or
pre-emptive right to purchase any new common
stock sold by the corporation.
   This right is a piece of paper giving each
stockholder the option to buy a specified number of
new shares, usually at a discount, during a
specified short period of time.
   These rights are valuable and can be sold in the
market.
Common Stock

   Shareholders also have limited liability,
meaning they cannot be held
responsible for the debts of the
company or lose more than their
original investment.
Characteristics of Common
Stocks
   Book value of a corporation is the
accounting value of the common equity as
shown on the balance sheet.
   It is the total value of common equity for a
corporation, represented by the sum of
common stock outstanding, capital in
excess of par value and/or contributed
surplus, and retained earnings.
   Dividing this sum – total book value– by the
number of common shares outstanding,
produces the book value per share.
Book Value for BCE Inc.
   BCE Inc. reported \$11.910 billion in common
shareholders’ equity for fiscal year-end 2003. This
is the book value of common equity. Based on the
year-end common shares outstanding of 923.989
million for that year (a figure obtained from the
company’s annual report), the book value per share
was \$12.88. (11.910 billion/923.989million)
   At the time the observation for BCE Inc’s book
value was recorded, the market price was in the
\$29 range. This implies that BCE’s market to book
ratio was \$29/\$12.88= 2.25
Value of Shares
   The market value or price of the equity is the
variable of concern to investors.
   The total market value for a corporation is
calculated by multiplying the market price
per share of the stock by the number of
shares outstanding.
   This represents the total value of the firm as
determined in the market place.
   The market value of one share of stock, of
course, is simple the observed current
market price.
BCE cont’d…

   At the time the observation for BCE
Inc.’s book value was recorded, the
market price was in the \$29 range.
This implies that BCE’s market-to-book
ratio was \$29.00/\$12.88=2.25
Dividends

   The only cash payments regularly made by
corporations to their stockholders.
   They are decided upon and declared by the
board of directors.
   The common stockholder has no specific
promises to receive any cash from the
corporation since the stock never matures
and dividends do not have to be paid.
Dividend Yield

   The income component of a stock’s
return stated on a percentage basis.
   It is commonly calculated as the most
recent annual dividend amount divided
by the current market price.
Payout Ratio

   The ratio of dividends to earnings.
   It indicated the percentage of a firm’s
earning paid out in cash to its stockholders.
   The complement of the payout ratio is the
retention ratio, and it indicated the
percentage of a firm’s current earning
retained by it for reinvestment purposes.
Payout Ratio for BCE Inc.

   BCE Inc’s 2003 earning were
\$1.90/share, and it paid an annual
dividend on its common shares of
\$1.20/share. Assuming a price for
BCE of \$29, the dividend yield would
be \$1.20/\$29.00, or 4.14%. The
payout ratio was \$1.2/\$1.9, or 63.16
percent and the retention ratio was
36.84% (i.e., 100% - 63.15 %)
Dividends cont’d…

   Dividends are declared and paid
quarterly, but to receive a declared
dividend, an investor must be a holder
of record on the specified date that a
company closes its stock transfer
books and compiles the list of
stockholders to be paid.
Important Dates!
   The ex dividend date is set at the second
business day before the record date, and
shares trade without the right to the
associated dividend on and after this date.
   Since stock trades settle on the third
the share two days before the record date
would not settle until the day after the record
date, and would not be entitled to receive
the dividend.
Important Dates cont’d…

   Shares are said to trade ex dividend
after the ex dividend date.
   This will be reflected in the share price,
which typically falls by an amount
close to the dividend amount on the ex
rights date.
Tax effects

   There may be tax impacts if you are
holding a stock or fund on the ex-
dividend date. The dividend is paid out
regardless of how long you held the
stock or fund, and that may be taxable
income to you.
Announcing Dividends for BCE Inc.

   Assume that the board of directors of BCE Inc.
meets on April 24 and declares a quarterly
dividend, payable on June 30. April 24 is called the
declaration date. The board will declare a holder-
of-record date, say, June 9. The books close on this
date, but BCE goes ex-dividend on June 7
(assuming June 7 and June 8 are regular business
days). To receive this dividend, an investor must
purchase the stock by June 6. The dividend will be
mailed to the stockholders of record on the payment
date, June 30.
Extra notes for Dividend
Dates…
   The key date to remember for dividend paying stocks is the ex-dividend date.
The Record Date, or Date of Record determines the Ex-dividend date, when
you must own the stock.
   In order to receive the upcoming dividend payment pay-out you must
already own or you must purchase the stock prior to the ex-dividend
date.
   It is important to know when you buy or sell stock, in some countries there is a
three-day settlement period (three stock trading days) on all buy and sell
orders.
   Here is an example: The ex-dividend date is two stock business days prior to
the record date. To be a stockholder on the Record Date you must purchase
the stock before the ex-dividend date. The latest date you can buy the stock
to be a stockholder on record and be entitled to the dividend would be one
day prior to the ex-dividend date to allow for the three stock-trading-day
settlement of the stock purchase. If you purchase the stock the day before the
ex-dividend date you would be a stockholder on the record date and would be
entitled to receive the dividend payment.
   You must be a stockholder on the record date to receive the dividend payment.
   You do not have to sell the stock after the record date to be entitled to the dividend.
However, you must hold without selling your stock until the ex-dividend date or after to be
entitled to the dividend payment. In this example, assuming that you purchased the stock
one day before the ex-dividend date, you would be a stockholder on record date. If you
sell the stock on the ex-dividend date, the buyer of your stock would be a stockholder one
day after the record date given the three stock business trading day settlement. The
person that bought your stock would not be entitled to receive the dividend.
   You only have to own the stock one day to be entitled to receive the dividend
payment.
   If you buy prior to the ex-dividend date, you are buying in time to receive and be entitled
to the upcoming dividend payment. Selling your stock on the ex-dividend date or after,