FIN3244 Final Exam

Stock Types : • Speculative Stocks

: Shares that lack sustained records of success but still offer the potential for substantial price appreciation o New products create high price appreciation potential o Stocks are subject to wide price swings and usually pay little or no dividends

Stock Types : • Market Capitalization

: total dollar market value of all of a company's outstanding shares o Small-cap stocks: less than $2 billion Mid-cap stocks: $2-10 billion Large-cap stocks: more than $10 billion

Describe a back-end load and a hidden load. How can you tell what kind of fees and charges a fund has?

A back-end load is a redemption fee/commission that an investor pays when he sells fund shares. Redemption fees typically decline over time and disappear entirely after the first three to five years of ownership. They are intended to provide an incentive for investors to retain the fund. The easiest way to know if a front-end load, back-end load or 12(b)-1 fee is charged is to look at the fee table found in the mutual fund's prospectus. Fee tables must (by SEC rules) fully disclose types and amounts of fees and charges at the time of purchase. Be aware, however, that these fees can be changed by the fund. The first time mutual fund shares are bought, a prospectus must be sent to the new investor (by SEC rules.) Periodically, thereafter, investors should request an updated prospectus from the mutual fund.

Define each of the following: b. Closed-end investment company

A closed-end investment company is a fund that issues a fixed number of outstanding shares and does not regularly issue new stock shares. These funds, which are relatively few compared to the number of open-end funds, operate with a fixed capital structure (relationship of debt to equity that a company has). They trade in the secondary stock market. Most are listed on the NYSE.

What is common stock? What is meant by the statement that holders of common stock are the residual owners of the firm?

A common stock is an equity investment that represents fractional ownership interest in a firm. It lets investors participate in the firm's profits. As residual owners of the company, common stockholders are entitled to dividend income (if paid) and a prorated share of the firm's earnings after all other obligations of the firm have been met (liabilities). Investors have no guarantee that they will ever receive any return on their investment.

What is the difference between load and no-load funds? What are the advantages of each type?

A load fund is a mutual fund that charges a commission to purchase fund shares. A no-load fund does not charge investors a commission. No-load funds offer an advantage because, by avoiding loads (can be as high as a total of 8.5%), investors can buy more fund shares with their given amount of capital. Other things being equal, this results in higher rates of return.

What is a mutual fund? Discuss the mutual fund concept, including the importance of diversification and professional management.

A mutual fund invests in a diversified portfolio of securities and issues shares in the portfolio to individual investors. Mutual funds represent ownership in a managed portfolio of securities. The mutual fund concept revolves around diversification. Diversification reduces the overall risk borne by the investor without reducing the average return. This, together with the fact that mutual funds provide professional management thus freeing individual investors from managing their own portfolios, makes mutual funds attractive to individuals.

Exchange-Traded Funds (ETF)

A security that reflects an index fund, but trades like a stock • Because it trades like a stock, an ETF doesn't have its NAV calculated every day like a mutual fund • Perks are getting the diversification of an index fund as well as the ability to short sell, buy on margin and purchase a small number of shares • Expense ratios are lower than that of average mutual funds • Brokerage commissions are paid on each trade • Actively managed ETFs o Still trading an index like a passive investor, but take advantage of short-term movements and can deviate from the index if they see fit • Examples: o "Diamonds" (DIA) tracks DJIA; "Spiders" tracks S&P 500

Contrast mutual fund ownership with direct investment in stocks and bonds.

Arguments for mutual fund ownership: • Greater level of diversification • Professional management • Investment program established with a limited amount of capital Arguments for direct investment in stocks and bonds: • Greater control over the types of investments made • Closer fit to risk preferences of the individual investor • Continuous pricing, faster trades, availability of different types of market orders

What is an automatic reinvestment plan?

Automatic reinvestment plans enable mutual fund investors to keep their capital fully invested. This is important because it lets investors earn fully compounded rates of return. Normally, dividends and capital gains distributions are paid in the form of cash. Through automatic reinvestment plans, however, those dividends and capital gains distributions are used to buy additional fund shares resulting in the number of shares owned by an investor increasing over time. Most reinvested plans allow investors to avoid brokerage commissions and front-end loads on their reinvested dividends and capital gains shares.

Define and differentiate between the following pairs of terms. c. Book value versus investment value.

Book value is an accounting measure of the amount of stockholder's equity in a firm. Book value indicates the amount of stockholder funds used to finance the firm. Investment value indicates what value an investor places on the stock. It is often referred to as a firm's 'intrinsic' value. Investment value is based on expectations of the risk and return. It can vary with different investors since different investors can come to different conclusions about the value of a stock share. It is the maximum price the investor will be willing to pay for the share.

. What is the difference between a cash dividend and a dividend paid-in-stock? Which would be more valuable to you? How does a dividend paid-in-stock compare to a stock split? Explain.

Cash dividends are simply dividend payments made to stockholders in the form of cash. They are a return to owners of part of the firm's profits. Cash dividends represent something of value since shareholders physically receive cash although the price of stock falls by the dividend amount on the ex-dividend day. A dividend paid-in-stock is an issue of new shares expressed and distributed as a percentage of each shareholder's existing shares. As with cash dividends, the market responds to these dividends by adjusting the market stock price accordingly. As an example, a stock trading at $50 per share that declares a 10% dividend paid-in-stock, would have its stock price drop to $45.45 ($50/1.10). Thus, an investor holding 100 shares before the stock dividend would hold 110 shares afterward. But the total market value of these shares would be the same, assuming all other things remain equal: $50 100 = $45.45 110. Dividends paid-in-stock are a substitute for cash dividends. In both instances, when dividends are paid, the firm's stock price adjusts downward proportionately so that the market value of the firm doesn't change.

How important are dividends as a source of return to common stock? What about capital gains? Which is more important to total return? Which causes wider swings in total return?

Dividends are an important source of return to stockholders even though they don't have the "bang" of capital gains. Dividend returns are never negative, although they can be zero. Capital gains have ranged from -27.57% (1974) to +38.32% (1975). Despite capital gains unquestionably providing higher returns than dividends, they are also responsible for the wide swings in year-to-year total stock returns. Dividends, in contrast, provide an element of stability and tend to shore-up returns in off-years.

Define and differentiate between the following pairs of terms. a. Treasury stock versus classified stock.

Firms do not "issue" treasury stock; these are simply shares of common stock that have been issued and subsequently repurchased by the issuing firm. This is generally done because the firm views the stock (of itself) as an attractive investment. Most treasury stock is later reissued by the firm and used for such purposes as mergers and acquisitions, employee stock option plans, or for payment of stock dividends. Treasury stock is not a form of classified stock. 'Classified' stock simply groups common stock into groups according to different voting rights and/or dividend obligations each group may have. For example, Class A stock might designate nonvoting shares that receive higher dividend rates, while Class B stock might designate shares with more votes than other shares.

What are dividend reinvestment plans and what benefits do they offer investors? Are there disadvantages?

Firms with dividend reinvestment plans (DRIPs) allow shareholders to automatically reinvest their dividends into additional firm shares. DRIPs provide investors with a convenient and inexpensive way to accumulate stock shares without paying brokerage commissions. Dividends paid into DRIPs, however, are taxed as ordinary personal income in the year received; just as if they'd been received as cash.

Why do most income stocks offer only limited capital gains potential? Does this mean that the outlook for continued profitability is also limited? Explain.

Income stocks generally have limited capital gains potential because they pay out large amounts of their earnings in dividends and re-invest less of their earnings into the finance growth of the firm. Returns from income stocks come mostly from current income rather than capital gains. This does not mean that these stocks are unprofitable. Most, in fact, are highly profitable and have excellent long-term future prospects.

How do closed-end funds differ from open-end funds?

Key differences between closed-end (CEFs) and open-end (OEFs) mutual funds include: (a) CEFs trade like stocks. The trade is between investors. OEFs are traded directly with the fund. (b) Large traders of CEFs (fixed number of shares) affect the buy or sell price, while trading large amounts of OEFs (unlimited number of shares) typically does not affect the price; i.e., CEFs are much less liquid than OEFs. (c) OEFs are traded (bought and sold) at net asset value, while CEFs have two values: a market value and a net asset value. These are rarely the same.

Define each of the following: d. Hedge funds

Like mutual funds, hedge funds sell shares (or participation units) in a professionally managed portfolio of securities. However, hedge funds are private partnerships that limit their clientele to 'accredited investors.' The manager is a general partner, while the investors are limited partners. They tend to limit the number of limited partners to fewer than 100. Hedge funds have limited reporting requirements to the SEC and are generally unregulated.

Describe an ETF and explain how these funds combine the characteristics of both open- and closed-end funds.

Most passively managed exchange-traded funds (the vast majority) are similar to index mutual funds but trade like stocks. Each share represents a basket of securities (a portfolio) that closely tracks one specific index. Because they trade on exchanges and are continually priced, ETFs are similar to closed-end funds. ETFs are low cost since they have no research fees and minimal operational expenses and tax efficient. ETFs are formed using a payment-in-kind creation unit. As a result, cash isn't used to create ETF portfolios. The result is that ETFs avoid all or most capital gains taxes and save investors capital gains distribution taxes. ETFs do distribute dividends and interest payments to shareholders. SPDRs are a specific type of ETF based on the S&P 500 Index. There are also mutual funds that track the S&P 500 Index. SPDRs are continually priced throughout the day, whereas, mutual funds trade only at their NAV at the close of the market. However, since SPDRs trade like stocks, brokerage fees are paid each time a trade is made. Index mimicking mutual funds tend to be no-load which means that numerous small purchases can be made without paying commission fees. Both SPDRS and index mutual funds have low costs, low turnover, and low tax liabilities. When choosing between a SPDR and an S&P 500 Index mutual fund, you must consider how you want to use the investment and its purpose.

Name some of the more important attributes of common stock.

One important attribute of common stock is that it lets investors participate in a firm's profits, thus offering them the possibility of attractive return opportunities. Another attribute of stock is its versatility. It can be used to meet different investment objectives. Relative to many investments, common stock is fairly simple and straightforward, making it easier to understand. Note: this does NOT mean that stock is easy to value. Stocks are liquid. They tend to be easy to buy and sell and their transaction costs are modest. Moreover, price and market information concerning firms is widely disseminated in the news and by the financial media.

Stock Types : • Tech Stocks

Represent the technology sector of the market o Include companies that produce computers, semiconductors, data storage, computer software, internet services, and wireless communications o May be hard to evaluate due to erratic or no earnings

How important is the general behavior of the market in affecting the price performance of mutual funds? Explain. Does the future behavior of the market matter in the selection process? Explain.

Since a mutual fund is really a large portfolio of securities, it behaves very much like the market as a whole or a given market segment (depending on what securities the portfolio holds.) When economic conditions are good and the stock market moves up, mutual funds do well. When the market falls, mutual funds do poorly. Some funds, such as sector funds, may not move with the overall market. This is one reason that some investors are attracted to different market sectors. Past performance gives an indication of how well the fund and its fund managers have done over time. And in this regard, it's important to look at past performance over extended (5- to 10-year) periods, covering both good markets and bad. If the fund manager has remained the same and done well in both up markets and down markets, there's a likelihood that s/he will do so in the future. Whether this is actually the case, however, is another matter. It's very important to try to get a handle on the future market direction. Combining past performance of existing fund managers with future market expectations helps to choose among funds.

What is a spin-off? In general terms, explain how a spin-off works. Are these spin-offs of value to investors? Explain.

Stock spin-offs involve the conversion of a firm's subsidiary or division to a stand-alone company by distributing stock in the new company to existing shareholders. For example, PepsiCo spun off its restaurant operations—Pizza Hut, KFC, and Taco Bell—into a new company called Tricon Global Restaurants (now called Yum Brands). Investors keep shares in their old firm while being given shares in the new firm. Investors are free to keep shares of both firms, sell both firms, or sell one of the firms and keep the other.

Briefly explain how the dividend decision is made. What corporate and market factors are important in deciding whether, and in what amount, to pay dividends?

The amount of dividends to be paid is decided by the firm's board of directors. The directors evaluate the firm's operational and financial conditions in determining whether dividends should be paid and, if so, in what amount. A variety of factors are incorporated into the board's final decision. These include: (a) The firm's current earnings or profits. (b) The firm's growth prospects. Firms with good investment opportunities tend to retain their earnings to use for new investments and, thus, tend to pay little, if any, dividends. (c) The firm's cash position. The board tries to insure that the firm has sufficient liquidity to meet a cash dividend of a given size. (d) All legal and contractual constraints imposed by loans (Conditions and amounts of dividend payment can be restricted by debt contracts.) (e) The dividend expectations of its shareholders. Failure to meet these expectations can lead to disastrous results in the stock market.

Why is the ex-dividend date important to stockholders? If a stock is sold on the ex-dividend date, who receives the dividend - the buyer or the seller? Explain.

The ex-dividend date (which occurs two or three business days prior to the date of record) determines who is eligible to receive the declared dividend. If a stock is sold on or after the ex-dividend date, and before or on the date of record, the previous owner (the seller) receives the declared dividend. If the stock is sold prior to the ex-dividend date, the new shareholder (buyer) receives the declared dividend. Going "ex-dividend" means the buyer is not entitled to the dividend since the stock is being sold "without" it.

What are the advantages and disadvantages of mutual fund ownership?

The main advantages of mutual funds are the provision of diversification, full-time professional management, and the ability of investors with modest amounts of capital to invest in them. Additionally, mutual funds handle all paperwork and record keeping, deal in fractional shares, and automatically reinvest dividends if the investor so desires. There are several disadvantages, however. Funds can be quite expensive to acquire if they are load funds or charges other types of fees such as 12(b)-1 fees. While it's expected that index-based, passively-managed mutual funds will have a slightly lower return than that of the index they benchmark, actively-managed mutual funds generally don't outperform the market, either. Only a few have been able to do so with any degree of regularity. This is partly a result of their high expenses which reduce investor returns.

What are some of the advantages and disadvantages of owning common stock? What are the major types of risk to which stockholders are exposed?

The major advantage of common stock ownership is the returns it offers. Because stockholders are entitled to participate in the prosperity of a firm, capital gains have unlimited potential. In addition, many stocks provide regular current income in the form of annual dividends. For most income-producing stocks, dividends tend to grow over time, further increasing a stockholder's return. Listed common stocks are also highly liquid and easily transferable. Their transaction costs are relatively low, market information is readily available, and the price per share is typically within reach of small (retail) investors. The risky nature of common stocks is the most significant disadvantage of ownership. As residual owners of the firm, no return is guaranteed and debt holders have first claim to the firm's assets. Furthermore, stock prices are subject to wide swings that make valuation difficult. Finally, the sacrifice in current income os stockholders is a disadvantage relative to other investments [debt securities (bonds that pay interest, for instance example.)] Principal risks to stockholders include the risks discussed in Chapter 9. No, I won't specifically go back and ask questions on these, but you should be aware of the terminology.

Define and differentiate between the following pairs of terms. b. Par value versus market value.

The par value of stock is its stated or face value and exists primarily for accounting purposes. Many stocks are issued with no par value. A firm's market value is equal to the number of common shares outstanding multiplied by the price of a stock share. It is literally, the price 'the market' places on a firm at some point in time.

In the absence of any load charges, open-end mutual funds are priced at (or very close to) their NAV, whereas closed-end funds rarely trade at their NAVs. Explain why this is the case. What are price premiums and discounts? What would cause a fund to trade at a discount? At a premium?

You can buy open-ended funds at their net asset value because you are dealing directly with the fund. Closed-end funds (CEFs) have both a market value (stock price) and a net asset value, which tend to differ. CEFs sell at a premium to net asset value in the unlikely case that the CEF's stock price exceeds the net asset value. It is uncommon for investors to pay more for a set of shares than their cost would be if purchased directly. CEFs sell at a discount to their NAV if more individuals are attempting to sell shares than buy them (supply and demand). They also sell at discounts if there are low future expectations for the fund's earnings. Low expectations can be the result of poor past fund performance, poor manager name recognition and small amounts of on-hand-cash making the fund unable to take advantage of market opportunities. Open-end mutual funds and closed-end funds should be evaluated on the future expected price performance of the underlying assets and the distribution of proceeds from current income and capital gains. Investors should typically avoid CEFs that sell at a premium and new CEFs (they have very high initial expenses.)

Hedge Funds

an aggressively managed portfolio of investments that uses advanced investment strategies in both domestic and international markets with a goal of generating high returns • Set up as private investment partnerships that are open to a limited number of investors • SEC has light regulations because they cater to sophisticated investors. • Law requires that majority of investors must earn a minimum amount of money annually and have a net worth of more than $1 million • If qualitative factors in analyzing an investment aren't within the context of the overall strategy, high risks can occur • Management fees are the same for mutual funds, but incentive fees are what motivates hedge fund managers, which average 10-20%

Type of Management : • Passive management

invests with a pre-determined strategy and does not use any market-timing or stock-picking techniques o The portfolio mirrors a market index o Reduces fund expenses: investing fees/taxes and avoids negative consequences for failing to correctly anticipate the future o Typically trades only when the underlying index changes o Most passively managed funds invest in a single asset class and hold little cash o Often more successful due to the minimal taxable gains distributions o For example, if IBM represents 1.7% of the S&P 500 Index, for every $100 invested in the fund, $1.70 goes into IBM stock

Type of Management : • Active management

manager makes specific and frequent buy/sell trades with the goal of outperforming an investment benchmark index o Attempts to improve returns and reduce risk through security selection and timing of purchase and sale o Most are very tax/expense inefficient 12(b)-1, marketing fees, management fees

Stock Types : • Small-cap Stocks

o Companies generally have annual revenues of less than $250 million o Usually don't have financial records o Spurts of growth can have dramatic effects on earnings and stock prices o Lack of liquidity can be problematic

Stock Types : • Large-cap Stocks

o Few in numbers, but account for 80-90% of U.S. equity market value o Price appreciation tends to lag behind small/mid-cap stocks, but less volatile

Stock Types : • Mid-cap Stocks

o Provide much of the sizzle of small-stock returns, without as much price volatility o "Baby Blues" - companies have all the characteristics of a regular blue chip except size Have rock-solid balance sheets, modest levels of debt, and long histories of steady profit growth

• Dividend Reinvestment Plans (DRIP)

o Shareholders can have their cash dividends automatically reinvested into additional shares of the firms common stock o No brokerage commissions and most firms allow partial participation o Pay taxes as if they were cash dividends in the year the dividend was received

• Stock Dividends

o Simply means that the dividend is paid in additional shares of stock o Do not hold any value o Taxes deferred until shares are sold

Stock Types : • Income Stocks

stocks that have a long and sustained record of regularly paying higher-than-average dividends o Ideal for investors who seek a relatively safe and high level of current income from their investment capital o High dividends = lack of potential growth

Dividends

• A firm's board of directors makes the dividend decision o Evaluate firms financial condition to determine if they should pay a dividend or not • Pay dividend? Repurchase shares? Do nothing? • Though firms don't need a profit to pay a dividend, they still play a vital roll in the dividend decision • EPS= net profit after taxes - preferred dividends/number of common stock shares outstanding • Board of directors also looks at the firm's growth prospects, cash position, and contractual obligations • Tend to increase as company's earnings grow and firm matures over time

Mutual Funds : Cons

• Can be costly: involve substantial transaction costs and sizeable commission fees (load charges) o Management, administrative, and operational fees • Mutual fund performance long-term is at best equal to what you would expect from the market as a whole

Taxes

• Capital gains distributions: payments made to mutual fund shareholders that come from the profits that a fund makes from the sale of its securities o Long-term: tax advantage, less than the marginal tax rate o Short-term: taxed like income at the marginal tax rate • Current income distributions o Dividend distributions: Same as short-term capital gains distribution - taxed at marginal tax rate o Interest distribution: Also taxed at marginal tax rate o **Distributions are still taxed even if they are reinvested into addition shares of the fund • Most of the time, it is better to invest in passively managed funds because taxes and commission expenses that build from actively managed trading can reduce your return o Ex. Your return on an active investment is $11, but your tax expense is $3, over a passively managed investment that has a return of $10 and only pays $1 in taxes

More on Dividends

• Cash Dividends o Most common type and should increase over time o Average annual growth is 3-5% o Dividend yield = annual dividends received per share/current market price of the stock o Dividend Payout Ratio: dividends per share/earnings per share o Tax break on dividends has been in effect since 2003

Common/Preferred Stock

• Classified common stock: Issues of different classes of common stock, each of which entitles holders to different privileges and benefits o Voting rights and dividend amounts usually differ in classes Often lets a small group control major decisions of publicly-traded firms • Preferred stock: Stock with stated dividend rate with preference over common stock dividends of the same firm

Closed-ended Funds

• Closed-end investment companies: operate with a fixed number of shares outstanding and do not regularly issue new shares of stock • The fund is then structured, listed and traded like a stock • Close-ended funds represents an interest in a specialized portfolio of securities that is actively managed and concentrates on a specific industry or geographical market • Eliminates manager's cash flow concerns • Premium = (share price-NAV)/NAV • Fixed number of shares: price determined by o Supply, demand, and NAV • Usually sells at a discount

Dividend Dates

• Declaration date: date dividend is announced • Date of record: date on which the investor must be a registered shareholder of the firm to be entitled the dividend - ends at the close of the business for that day o These stockholders are referred to as holders of record • Payment date: generally follows the record date by a week or so and is the actual date the dividend checks are mailed to holders of record • Ex-dividend date: dictates whether you were an official shareholder and therefore eligible to receive the declared dividend o Allows time for bookkeeping o Stock prices fall by dividend amount

12(b)-1 fees

• Designed to help funds cover their distribution and marketing costs • Management fee: compensation to managers who administer the fund's portfolio o Paid by all funds o Usually 1% of average net funds under management • Taxes on capital gains and current income o Usually paid by shareholders • Investment companies levy management and 12(b)-1 fees annually, regardless of the funds performance

Mutual Funds : Pros

• Diversification o Pooled diversification: individuals pool their resources for the collective benefit of all the contributors o Professional management: the fund is able to offer better investment expertise than individual investors o Modest amount of investment capital Services include automatic reinvestment of dividends, withdrawal plans, and exchange privileges o Convenience Relatively easy to acquire, funds handle the paperwork/record keeping, prices are widely quoted, possible to deal in fractional shares

No-load funds

• Don't charge commissions because shares are distributed directly by the investment company, instead of a secondary party • Advantage of no-load funds is the cost savings tend to give investors a head start in achieving superior rates of return • Hard to find because many are becoming 12(b)-1 funds, but still have been shown to outperform load funds

Common Stock

• Equity Capital: Evidence of ownership in a firm • Each share entitles an owner to an equal ownership position o Equal vote and equal voice in management • The common stockholders own the company, the more shares you own, the bigger your ownership position • All corporations "issue" common stock, but most are never traded because the firms are either too small or are family (privately) controlled • Publically trades issues: shares that are readily available to the general public o Bought and sold in an open market

Investing in Foreign Stock

• Globalization of financial markets is increasing • 1970- U.S. stock market accounted for 2/3 of the world market o Today U.S. holds 35% • 6 countries = 80% if world equity market o Japan, Germany, and Canada are part of the 6 • Non-U.S. Market returns: partly due to currency exchange rates rather than increases in firm value • **International investing is more complex/risky than domestic investing

Issuing New Shares

• IPO: determine number of firm's shares at a specific price that are available to the public o Proceeds from "new" shares go to the firm o Existing shareholders receive proceeds from selling shares to new investors • Rights offering: existing stockholders are given the first opportunity to buy the new issued shares in proportion to their current ownership • Results from both IPO and Rights Offering: o Firms have more equity in it's capital structure o Number of shares outstanding increases • Stock Spin-offs: occurs when a company gets rid of one of its subsidiaries or divisions o Creates a stand-alone company and distributes stock in that company to existing shareholders o Normally execute stock spin-offs if they believe subsidiary is no longer a good fit or if the company wants to focus on their core products • Stock Splits: a firm announces that it will increase the number of shares outstanding by exchanging a specified number of new shares for each outstanding share of stock o Companies use stock splits when they want to enhance their stock's trading appeal by lowering its market price • Treasury stock: Companies buy back their own stock to reduce the number of outstanding shares o Firms do this when they feel their stock is undervalued in the marketplace o Buy back at market price o Treasury stock usually used for mergers, to meet employee stock option plans, or as a means for paying dividends o Makes stock appealing to outside investors

Load Funds

• One-time-only costs o Load charge: commission you pay when you buy shares in a fund o Back-end Load: Charged commission when shares are sold (usually decreases over time; ultimately disappearing) o Load mutual funds: often sold through brokers o **low-load funds: only charge 2-3% commission

Open-End Funds

• Open-end investment company: investors buy their shares from, and sell them back to, the mutual fund itself. o No limit, other than investor demand, to the number of shares the fund can issue • Never trades between individuals • Fund's asset value: sum of the closing prices of all fund portfolio securities • Have greater liquidity • Net asset value (NAV): represents the underlying value of a share of stock in a particular mutual fund o Calculated once a day o NAV = (total market value of all assets held by the fund - any liabilities)/number of fund shares outstanding • No continuous pricing, traders are made at the next (future) NAV price

Common Stock Values

• Par value: Stated or face value of a stock. o Except for accounting purposes, it is relatively useless • Book value: represents the amount of stockholders' equity in the firm o Indicates the amount of stockholder funds used to finance the firm • Market value: simply the prevailing market price of an issue o Indicates how the market participants as a whole have assessed the worth of a share of stock o MV of firm: (market price of stock) x (# of outstanding shares) • Investment value: indicates the worth investors place on the stock - in effect, what they think the stock should be trading for o Based on predictions of how much money they will make from capital gains and dividends

Disadvantages of Stock Ownership

• Prone to business, financial, purchasing power, market, and event risks • Government control, foreign competition, and state of the economy can affect sales/profits, which will affect price behavior of stocks and dividend payments • Not only is the future outcome of a company and it's stock uncertain, but the evaluation of stock performance is also extremely complex and far from perfect • Stock ownership sacrifices current income o Stocks typically have lower returns and greater uncertainty compared to debt investments • Wide swings in earnings and stock market performances are common • Yield = Annual current income/current market price

Advantages of Stock Ownership

• Stocks are so appealing because they have a greater chance for higher returns than long-term bonds and U.S. treasuries. o Usually provide attractive, highly competitive returns over a long period of time. • Stocks provide protection from inflation because over time their returns exceed the inflation rate • Highly liquid: easy to buy and sell with low transaction costs • Unit cost per share is cheaper than bonds • Tax costs are relatively small • Easy accessible market info keeps stocks selling at fair prices

Actively-Managed Fund Performance

• Successful if invested at below market performance o Hard to consistently beat the market indexes o Some mutual funds maintain pace with their benchmark stock index (average value): many don't even do that Risky even to buy at average value o If the IPO is sold at a premium, it is usually because it includes management expenses

Stock Price Behavior

• The economy and average stock returns typically move together • Capital gains create higher returns than dividends • Stock investing is risky: a firm must meet all other financial obligations before paying stockholders o There is no guarantee stocks receive any return on their investment

What is a 12(b)-1 fund? Can such a fund operate as a no-load fund?

A mutual fund can legally refer to itself as a no-load fund if it charges no more that ¼ of a percent (.25%) in annual 12(b)-1 fees. A true no-load fund doesn't charge any 12(b)-1 fees. Load funds are limited by law to a maximum annual 12(b)-1 fee of 1%. 12(b)-1 fees can significantly reduce returns over time.

What is a stock split? How does it affect the market value of a stock share? How do you think the stock price would be affected? Explain.

A stock split occurs when a firm announces its intention to increase the number of common shares of stock outstanding by exchanging a specified number of new shares for each existing share. Stock splits are executed to lower the price per share of a stock. This may enhance the stock's trading appeal (Trading Range Theory) since it makes stock shares more affordable to small investors. It also reduces the likelihood of investors thinking a stock is overpriced as a result of an increase in cost per share. Stock splits can also send a message (Signaling Theory) to the market that the firm believes its stock is undervalued. This is because stock splits are attention-getting events in the business world and often result in the re-examination of a firm. Stock prices fall proportionately to account for the split. Thus, a $100 stock will fall to $50 after a 2 for 1 split. Stock splits are viewed as positive events by the market. Studies show that despite stock splits being merely cosmetic (no value change), on average, firms that split their shares tend to have abnormal returns for the following year.

Define each of the following: c. Exchange-traded funds

An exchange-traded fund (ETF) is a type of open-end investment company (its assets are primarily a portfolio of securities) that trades as a listed security on one of the stock exchanges. It's a hybrid product that combines some of the best features of mutual funds with closed-end funds.

Define each of the following: a. Open-end investment company

An open-end investment company is a mutual fund in which investors buy their shares from and sell them back to the mutual fund (direct investing.) The number of shares an open-end fund can issue is unlimited and does not affect the mutual fund share price. They are, by far, the most common type of mutual fund.

Stock Types : • Cyclical Stocks

Issued by companies whose earnings are closely linked to the general level of business activity o Generally do well when economy is improving, especially in the early stages of economic recovery o Prices tend to follow the business cycle

Briefly describe how mutual funds operate.

Mutual funds are open-ended investment companies. Investors in mutual funds are essentially buying a small piece of a large, well-diversified portfolio of securities. Mutual funds receive money from shareholders and invest it in a securities portfolio. Investors in a given mutual fund are all part-owners of that portfolio.

. What is the difference between a cash dividend and a dividend paid-in-stock? Which would be more valuable to you? How does a dividend paid-in-stock compare to a stock split? Explain.(CONTINUED)

Shareholders, however, typically view cash dividends and dividends paid-in-stock differently. Shareholders may wonder if dividends aren't paid in cash, why not? Those who bought the firm for current income may be negatively impacted by not receiving expected cash payments. If these concerns cause selling pressure on the firm's shares, the firm's stock price may drop by more than the dividend payout. With a cash dividend, the investor actually receives spendable cash. With a dividend paid-in-stock, the investor receives more of what he already owns. The cash dividend may be considered by investors to have greater value. Stock splits occur when a firm exchanges new shares for existing shares owned. In essence, dividends paid-in-stock are a form of stock split, but they are viewed differently by the market. Stock splits are considered positive events whereas dividends paid-in-stock may cause investor concern. Stock splits tend to raise investors' expectations of future firm profits resulting in abnormal returns for stock-splitting firms.

Stock Types : • Growth stock

Shares that have experienced, and are expected to continue experiencing, consistently high rates of growth in operations and earnings o Normally pay little or nothing in dividends, almost all retained earnings are reinvested to help rapid financial growth

Stock Types : • Defensive Stocks

Stocks that tend to hold their value even when the economy starts to decline. o Include shares of public utilities, industrial/consumer good companies that produce beverages, foods, or drugs

Identify 3 potential sources of return to mutual fund investors and briefly discuss how each could affect total return to shareholders.

The three sources of return for mutual funds are (1) dividend/interest distributions, (2) capital gains distributions, and (3) capital gains (changes in the fund's net asset value when mutual funds shares are sold.) Each of these components impacts the mutual fund's total return.

Stock Types :• Blue-Chip Stocks:

issued by large, well-established firms that have impeccable financial credentials o These companies hold important, often leading, positions in their industries and frequently set the standards by which other firms are measured o Some give consistently high dividend yields while others are more growth oriented o Relatively lower risk result of financial stability

Mutual Fund

type of financial services organization that receives money from a pool of shareholders and then invests those funds in a portfolio of securities • Represents the financial product sold to the public by an investment company • Investors delegate most of the security selection decision to professional money managers, but still have partial ownership of the portfolio