“Finance exam q & as (investing)”;
Last year Marcellino graduated from high school and received several thousand dollars from an uncle as a graduation gift. Marcellino, now in his first year of college, just heard of a guy in his dorm that invested in an oil exploration company and made a huge profit in a few months. Marcellino likes the idea of making some money fast and is considering investing his graduation gift money in a similar stock. Marcellino’s roommate, Luc, just finished a personal finance course and is concerned that Marcellino may be getting himself into trouble. Luc knows that Marcellino likes to shop online, has run up a fairly large credit card bill, and has trouble balancing his budget on a monthly basis. In addition, Marcellino really doesn’t know much about investing or how people actually “make money investing.” Luc has asked you to help him work through the following questions so that he can talk to Marcellino about his investment plans. (25 Points)
Before investing any money, what five things should Marcellino do first?
Before investing any money, the five things Marcellino should do first are:
- evaluate your financial health,
- define your financial goals,
- develop a plan of action,
- implement your plan, and
- review your progress, reevaluate, and revise your plan.
Is Marcellino’s strategy for investing in an oil exploration stock to make quick profits investing or speculating? Support your answer.
Marcellino’s strategy for investing in a oil exploration stock to make quick profits is speculating because it sounds too good to be true. His plan to make money in such a short term, reflects that he is depending on supply and demand to determine prices and generate income.
Luc started talking to Marcellino about market efficiency and market timing. Based on what you now know, how likely is it that Marcellino can pick a stock that will “beat the market?”
The likelihood that Marcellino can pick a stock that will “beat the market” is very low. The investment theory called efficient market hypothesis claims that it is impossible to “beat the market.” Stock market efficiency and timing causes existing prices to always be current and require all information to be present.
Calculate Marcellino’s average annual rate of return if he purchases shares in an Internet stock at $25 per share, holds the shares for 3 years, and sells them for $65. What is his after-tax rate of return if he is in the 25% marginal tax bracket? (Show support)
1-.25=.75
What potentially significant disadvantage does Marcellino face if he sells his stock for $65 per share after only 10 months and incurs a short-term capital gain?
The potentially significant disadvantage Marcellino faces if he sells his stock for $65 per share after only 10 months and incurs a short-term capital gain, is that with short-term capital gains, he ends up paying more money to have that time period. They have higher tax rates, brokerage fees, and other costs.
What other financial risks does Marcellino face if he invests in an exploration stock?
Other financial risks does Marcellino face if he invests in an exploration stock are business risk, political and regulatory risk, and exchange rate risk.
By investing in two unrelated domestic stocks rather than in just one stock, would Marcellino increase or decrease his systemic risk exposure? What about his unsystematic risk exposure?
Holding one stock does not increase systemic risk, but it does increase unsystematic risk. By investing in two unrelated domestic stocks, Marcellino should reduce the volatility of his portfolio due to unsystematic business specific risk.
Luc has urged Marcellino to invest for the long term using a diversified approach. Marcellino is skeptical. Explain why Luc is probably correct.
Luc is correct because using a diversified approach would allow Marcellino to reduce unsystematic risk. Allowing bad returns from a few stocks to be countered by higher returns in other stocks is good.
Pete and Jessica, on the advice of their next-door neighbor, recently purchased 500 shares of a small-capitalization Internet stock, trading at $80 per share. Their neighbor told them that the stock was a “real money maker” because it recently had a two-for-one stock split and would probably split again soon. Even better, according to the neighbor, the company was expected to earn $1 per share and pay a $.25 dividend next year. Pete and Jessica have so far been less than impressed with the stock’s performance-the stock has underperformed the S&P 500 Index this year. Pete & Jessica have come to you for some independent advice. (25 Points)
Assuming that the stock actually splits two for one, how many shares will Pete and Jessica own? What will be the market value of their stock after the split? How will the split affect the value of the holdings? Was their next-door neighbor correct in thinking the stock made the stock a “real money maker?”
Pete and Jessica will own 1,000 shares. The market value of their stock after the split is $40,000. The market value will remain the same before and after the stock split. Their neighbor was incorrect in thinking that a stock split will automatically increase the value of the stock.
Using the information provided, calculate the stock’s P/E ratio. Would you classify this investment as a growth or value stock?
The P/E ratio is 80. This investment is a growth stock.
Since Pete, is worried about the price of a stock, explain to him how and why corporate earnings are so important in the valuation of common stocks.
The long-term value of any stock is most closely aligned with a firm's earnings. The faster a firm can compound earnings, the greater the long-term value of the firm's stock. Corporate earnings are important because analysts use earnings as a proxy for a company's ability to pay dividends in the future. Thus, Pete should pay close attention to the earnings outlook for the stock.
Should Pete and Jessica be using the S&P 500 Index as a benchmark for this stock? Why or why not? What benchmark recommendation would you make?
The S&P 500 index is an inappropriate benchmark for Pete and Jessica because the makeup of the index does not represent the type of company they own. Pete and Jessica should consider tracking the performance of their stock to an index comprised of other Internet companies.
Yesterday they received a cold call from a stockbroker wanting to sell them an initial public offering in a cable television company. Jessica was worried because the broker promised a “no-lose guarantee.” Should they invest with this type of broker?
They should definitely not invest with this or any other broker who makes cold calls promising unlimited returns or guarantees against losses for an investment.
Name at least five things Pete & Jessica need to look out for when making stock investments.
Be aware of excessive transactions undertaken by broker "churning", if they use a broker. Be aware of misrepresentation, telephone sales pitches, or recommendations based on "inside information" or other tips. Be prepared for losses and be wary of claims for easy profit or "hot tips", if they use an online account. Be aware of psychological impacts on investment decisions. Employ an appropriate investment strategy and asset allocation model that meets their risk tolerance.
Miguel, a recent college graduate who heard that you know something about investing, wants to ask about investing in bonds. Miguel indicated that, according to his friends, the stock market was too volatile and bonds were a safer place to invest. Miguel admitted that he really didn’t know much about either stocks or bonds but that he hoped to start saving so that he could purchase a house in the next 5 years. Miguel also mentioned that he had heard about preferred stock and real estate as alternatives to bonds. His roommate recommended that he buy a preferred stock that pays a $4.50 annual dividend or purchase farmland outside his hometown. Answer the following questions in a way that will help Miguel learn investment concepts. (25 points)
List four advantages and four disadvantages of investing in bonds.
One advantage is the volatility of bonds is lower than that of equities. Another is that bonds are liquid. A third advantage is that bonds comes with indentures and covenants. Lastly, there are many types of bonds. One disadvantage is that bonds are subject to lots of risks. Another is that price changes in a bond will affect mutual funds that hold these bonds. Third, some bonds are callable in that though the company agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early and it creates reinvestment risk. Finally, the market price of a bond will fall due to an unanticipated downgrade.
If Miguel thinks that interest rates are going to increase, what type and maturity of bond should he purchase? What type and maturity should he avoid? Why?
He should purchase a short-term bond and avoid a long-term bond. Rising interest rates make prices of bonds go down, but the longer the maturity, the farther prices will fall. Bonds of shorter maturities will do better than those with longer maturities in a rising interest rate because of their prices.
Develop a checklist of rules that Miguel should use when purchasing a bond.
- When in doubt, buy a treasury bond since it’s better to be safe than sorry.
- Match your bond’s maturity to your investment time horizon.
- Stick to large issues.
- Buy your bond when it’s first issued rather than in the secondary market.
- Avoid bonds that might get called.
- Limit yourself to bonds rated AA or above.
- Think about the effect of taxes.
- Keep the inverse relationship between interest rates and bond prices in mind.
- If you’re buying a corporate bond, avoid losers.
To be as safe as possible, what bond maturity should Miguel choose to meet his home purchase goal? What type(s) of risk does this strategy reduce or avoid?
Miguel should choose a mortgage bond. It is secured by a lien on real property. The value of the real property is greater than that of the mortgage bonds issued, providing the investor with a margin of safety in case the market value of the secured property declines. With bankruptcy, the bond trustees have the power to sell the secured property and use the proceeds to pay the bondholders. If the proceeds from this sale don’t cover the bonds, the bondholders fall in line with the other creditors who are owed money.
Explain to Miguel why he might want to consider investing in preferred stock rather than bonds.
What is the fair market value of the preferred stock that Miguel is considering purchasing if his required rate of return is 8 percent?
If Miguel really wants to purchase real estate to meet his objective, is a direct or indirect real estate investment more appropriate for him? Explain your answer in terms of liquidity, diversification, and safety.
Rick Phillips has usually been just a market watcher and not a market participant; however, he recently received $15,000 for the movie rights to his new book. Rick has never before had the resources to invest and therefore owns no other security investments, but he has followed several telecom stocks over the past year. The share prices have fluctuated dramatically, but Rick is definitely interested in this type of stock. He feels that wireless telecommunication companies offer great possibilities. When you asked Rick if he was comfortable with the risk associated with such an investment, he indicated that he would be if superior returns could be obtained. (25 points)
Given the fact that Rick has only $15,000 to invest, explain why he should consider investing in mutual funds rather than individual stocks.
In what type(s) of stock mutual fund(s) would you recommend Rick invest? Why?
In helping Rick make an investment choice, what factors would you explain to him as most important when choosing a mutual fund?
Although most mutual funds will provide Rick with some level of diversification, what type of risk will Rick still be exposed to if he purchases a single mutual fund.
To assure Rick of the liquidity and marketability of his investment, would you recommend that he invest in an open-end or a closed-end mutual fund? Why?
In terms of costs, would you recommend load or no-load funds to Rick? Why?
Develop a model portfolio of three mutual fund types (e.g., index, growth, bond, etc.) to help Rick understand the benefits of diversification. Explain your choices. Be sure to consider issues of risk and volatility.