Victor and Maria have decided to increase their contribution to their investment
ID: 2619573 • Letter: V
Question
Victor and Maria have decided to increase their contribution to their investment portfolio since Victor is now age 59 and thinking about retiring in five years. For years, they have followed a moderate-risk investment philosophy and put their money in suitable stocks, bonds, and mutual funds. The value of their portfolio is now $420,000, and this is in addition to their paid-for rental property, which is worth $300,000. They plan to invest about $8,000 every year for the next five years.
(a) Why should Victor and Maria consider buying common stock as an investment with the additional money? Why or why not?
(b) If Victor and Maria bought a stock with a market price of $50 and a beta value of 1.8, what would be the likely price of an $8,000 investment after one year if the general market for stocks rose 6 percent?
(c) What would the same investment be worth if the general market for stocks dropped 8 percent?
(d) Review the types of stocks in Table 14-1 on page 428 and select two that you think Victor and Maria might prefer as investments. Explain why.
(e) Discuss the positives and negatives of preferred stock for Victor and Maria.
Jable 14-1 Characteristics of Stocks Type of Stock Income Stock Characteristics Company that pays a cash dividend higher than that offered by most companies. Stocks issued by telephone, electric, and gas utility companies; beta often less than 1.0 Growth Stock Corporations that are leaders in their fields, that dominate their markets, and that have several consecutive years of above- industry- awareness of such corporations is widespread, and expectations for continued growth are high. The P/E ratio is high; betas of 1.5 or more average earnings; pays some dividends. In vestor Blue-Chip Stock A company that has been around for a long time, has a well regarded reputation, dominates its industry (often with annual revenues of $1 billion or more), and is known for being a solid relatively safe investment; betas are usually around 1.0 Countercyclical A company whose profits are greatly influenced by changes in the economic business cycle in consumer-dependent industries, like automobiles, housing, airlines, retailing, and heavy machinery, betas of about 1.0. A stock with a beta that is less than 1.0 is called a countercyclical (or defensive) because it exhibits price changes contrary to movements in the business cycle, thus prices remain steady during economic downturns. Examples are cigarette manufacturers, movies, soft drinks, cat and dog food, electric utilities, and groceries. Stock Value Stock A company that grows with the economy and tends to trade at a low price relative to its company fundamentals (dividends, earnings, sales, and so on) and thus is considered under-priced by a value investor; beta 1.0 to 2.0 Large-Cap, A company's size classification in the stock market is based on Small-Cap, and Mid-Cap stocks market capitalization. Large caps are those firms valued at or more than $10 billion. Mid-caps are $2 billion to $10 billion Small caps is $300 million to $2 billion Tech Stock A company in the technology sector that offer technology-based products and services, biotechnology, Internet services, network services, wireless communications, and more Speculative A company that has a potential for substantial earnings at some time in the future but those earnings may never be realized betas above 2.0. Examples: computer graphics firms, Internet applications firms, small oil exploration businesses, genetic engineering firms, and some pharmaceutical manufacturers. StockExplanation / Answer
(a) Common stock i.e. the equity share of a company gives Maria and Victor a share in the ownership of the company they invest in. So the biggest reason to invest in equity shares of any company is that you get to own a part of business you think will work and give you good returns during your investment period based on your analysis. However, there is a higher risk in owning the company i.e. on liquidation or during the times the company does not do well, the debt holders have 1st priority for repayment followed by preference shareholders and then followed by equity shareholders. So high risk might not be appropriate to take if the investment horizon is small and the company has a huge gestation period. The required return for equity shareholders is always more than debt holders or preference shareholders as equity shareholders expect to be compensated for the higher risk that they take whereas returns for debt holders and preference shareholders is restricted to the predetermined interest and dividend respectively. So before investing in common stock, Victor and Maria must consider all these factors and then make a rational decision.
(b) Investment amount = 8000 ; Share price = 50;
Therefore number of shares purchased = Investment amount/Share price
number of shares purchased = 8000/50 = 160 shares
Beta measures the sensitivity of the company returns with the return of the market i.e. if the market increases by 1%, our specific stock shall increase by 1.8%)
The beta (given) is 1.8
So here, when the market increases by 6%, our specific stock shall go up by = (market increase * beta)%
i.e the stock price = 6*1.8 = 10.8%
So the value of the investment of 8000 will now be = No. of shares purchased * (original purchase price*stock price increase % as calculated above)
Value of $ 8000 investment = 160 *(50 + 10.8%) = $ 8864
(c) Here we calculate value of $ 8000 portfolio if market stock fell by 8%
We know (as explained above) that when market stock falls by 1%, the company stock shall fall by = (market stock*beta)%
Company stock price fall % = 8*1.8 = 14.4%
So the value of the investment of 8000 will now be = No. of shares purchased * (original purchase price - stock price decrease % as calculated above)
Value of $ 8000 investment = 160 *(50 - 14.4%) = $ 6848
(d) Maria and Victor are looking for appropriate stock to invest in - this decision should be taken keeping in mind the fact that retirement period is in 5 years which means they are looking for stock with considerable dividend payout ratio so that there is regular flow of income during their post retirement years. Accordingly, Income stock suits their investment objective and expectation of receiving regular cash flow. Another stock best suited for them is blue chip company stock since they are a really safe investment however it should be ensured that such stocks pay regular dividend.
(e) Maria and Victor have 5 years as their investment period after which they expect regular cash flow to be received. In such circumstances, the fact that preference shares have fixed dividend which have to be paid before making any payment to shareholders makes it a safe bet for them. However the reduced riskiness comes at the cost of reduced returns as compared to equity shareholders. So such shares have both positives and negatives and Maria & Victor need to consider all the factors and then arrive at a rational conclusion.
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