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Chapter 4

FIN 501 Chapter Notes - Chapter 4: Preferred Stock, Common Stock, Current Yield

Course Code
FIN 501
Edward Blinder

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FIN501 investment analysis I
Financial assets can be grouped into three broad categories, and each can be subdivided into few major subtypes
Distinctions can become blurred because some financial instruments are hybrids, meaning they are combinations of
the basic types
Money market instruments
Fixed-income securities
Common stock
Preferred stock
Some interest-bearing assets pay interest implicitly and some pay explicitly, but the common denominator is that the
value of these assets depends on interest rates
o They pay interest because they all begin life as a loan so they are all debt obligations of some issuer
Types of interest-bearing assets:
1. Money market instruments: debt obligations of large corporations and governments with an original
maturity of one year or less
EX. Bank of Canada sells T-bills on a discount basis bi-weekly; other instruments include bank
certificates of deposit (CDs) and corporate, provincial and municipal money market
Potential gain from money market instrument is fixed because the owner is promised a fixed
future payment and has relatively low risk
Risk of default is the possibility that the borrower will not repay the loan as promised
2. Fixed-income securities: longer-term debt obligations, often of corporations and governments, that
promise to make fixed payments according to a preset schedule
Live exceeds 12 months at the time they are issued
Current yield: annual coupon divided by the current bond price
Prices for fixed-income securities are quoted in different ways, depending on, among other
things, what type of security is being priced
Potential gain from owning a fixed-income security comes in two forms:
i. There are fixed payments promised and final payment at maturity
ii. Prices of most fixed-income securities rise when interest falls, so there is possibility
of a gain from a favourable movement in rates
EX. Suppose you buy $1 million face amount of a 6%, two-year bond.
Receive $60,000 each year in “coupon” payments. In two years in addition to your final $60,000 coupon payment, you will receive $1
million FV.
Price you pay for the bond depends on market conditions.
Two forms of equities:
1. Common stock: represents ownership in a corporation
As a part owner, you are entitled to your pro rata share of anything paid out by the company
and you the right to vote on important matters regarding the company
If it were to be sold or liquidated, you would receive your share of whatever was left over
after all of the company’s debts and other obligations (such as wages) are paid
Potential benefits from owning stock:
i. Cash dividends, which are paid strictly at the discretion of a company’s board of
directors, which is elected by shareholders, and can, at any time, increase,
decrease, or omitted all together
ii. The value of your stock may rise because share values in general increase or
because the future prospects for your particular company improve
Downside is reversed: shares may lose value if either economy or
particular company falters
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