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Chapter 4

Mutual Funds and Other Investment

Companies
INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

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 Investment Companies
An investment company pools and invests the funds of
individual investors in securities or other assets.
• Record keeping and administration.
• Diversification and divisibility.
• Professional management.
• Lower transaction costs.

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 Net Asset Value (NAV)
Investment companies pool assets of individual investors, but
also need to divide claims to those assets among investors.
Calculation of NAV

Market Value of Assets  Liabilities

NAV 
Shares Outstanding

© McGraw Hill 3
 Mutual Funds: Investment Policies 1

Money market
• Invest in money market securities such as commercial
paper, repurchase agreements, or CDs.

Equity
• Invest primarily in stock.

Sector
• Concentrate on a particular industry or country.

Bond
• Specialize in the fixed-income sector.

© McGraw Hill 4
 Mutual Funds: Investment Policies 2

International
• Global, international, regional, and emerging market.

Balanced
• Designed to be candidates for an individual’s entire
investment portfolio.
• Hold both equities and fixed-income securities in relatively
stable proportions.
• Many are funds of funds.

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 Mutual Funds: Investment Policies 3

Asset allocation and flexible funds

• Hold both stocks and bonds.
• Engaged in market timing.
• Not designed to be low-risk index.
• Tries to match the performance of a broad market index.

© McGraw Hill 6
 Mutual Funds: How Funds Are Sold
How Funds Are Sold
Directly by the fund underwriter (direct-marketed funds).
• Sold through the mail, various offices of the fund, over the
phone, or over the Internet.
Indirectly through brokers acting on behalf of the underwriter
(sales-force distributed).
• Broker or financial advisers receive a commission for selling
shares.
• Potential conflict of interest.
Financial supermarkets.
• Sell shares in funds of many complexes.
• Broker splits management fees with the mutual fund company.
© McGraw Hill 7
 Exchange Traded Funds (ETFs)
ETFs are offshoots of mutual funds that allow investors to trade
index portfolios just as they do shares of stock.
• Examples: “spiders,” “diamonds,” “cubes,” and “WEBS.”

Potential advantages
• Trade continuously like stocks.
• Can be sold short or purchased on margin.
• Cheaper than mutual funds.
• Tax efficient.

Potential disadvantages
• Prices can depart from NAV.
• Must be purchased from a broker (for a fee).
© McGraw Hill 8
 Mutual Fund Investment Performance
Performance of actively managed funds.
• Wilshire 5000 index used as a benchmark for the
performance of equity fund managers.
• Wilshire 5000 average return was 12.49%, which was
0.96% greater than the average mutual fund from 1971 to
2020.

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 Information on Mutual Funds 2

“Encyclopedias” of mutual fund information.

• www.morningstar.com.
• www.finance.yahoo.com/funds.
• www.ici.org.
• Directory of Mutual Funds.

© McGraw Hill 10
 Chapter 5

Risk, Return, and the Historical

Record
INVESTMENTS
THIRTEENTH EDITION
BODIE, KANE, MARCUS

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
© McGraw Hill
 Interest Rates and Inflation Rates
Fundamental factors that determine the level of interest
rates:
1. Supply of funds from savers, primarily households.
2. Demand for funds from businesses to be used to finance
investments in plant, equipment, and inventories.
3. Government’s net demand for funds as modified by
actions of the Federal Reserve Bank.
4. Expected rate of inflation.

© McGraw Hill 12
 Real and Nominal Rates of Interest
A nominal interest rate is the growth rate of your money.
A real interest rate is the growth rate of your purchasing
power.
rnom  Nominal Interest Rate
rreal  Real Interest Rate
i  Inflation Rate
rnom  i
rreal 
1 i
Note : rreal  rnom  i

© McGraw Hill 13
 Risk and Risk Premiums: Holding Period
Returns
Sources of investment risk.
• Macroeconomic fluctuations.
• Changing fortunes of various industries.
• Firm-specific unexpected developments.

Holding period return (HPR) is the return realized from a

price change and any cash dividends collected:

Ending price of a share  Beginning price  Cash dividend

HPR 
Beginning price

© McGraw Hill 14
 Expected Return 1

Consider a single period of time—say a year. We have two stocks, L and U,

which have the following characteristics:
Stock L is expected to have a return of 25% in the coming year.
Stock U is expected to have a return of 20% for the same period.
There are two states of the economy, which means that there are only two
possible situations, and the two are equally likely to occur:
Economy booms, in which case Stock L will have a 70% return and Stock U will
have a 10% return.
Economy enters a recession, where Stock L will have a -20% return and Stock
U will have a 30% return.
State of Probability of State of Rate of Return if State Rate of Return if State
Economy Economy Occurs For Stock L Occurs For Stock U
Recession .50 −20% 30%
Boom .50 70 10
1.00

Expected return is the return on a risky asset expected in the future.

© McGraw Hill 8-15
© McGraw Hill
 Expected Return 2

Expected return on Stock U, E(RU), is 20%, found by:

E(RU) = .50 × 30% + .50 × 10% = 20%.

Expected return on Stock L, E(RL), is 25%, found by:

E(RL) = .50 × −20% + .50 × 70% = 25% .

The following table illustrates these calculations:

© McGraw Hill 8-16

© McGraw Hill
 Expected Return
(concluded)
Using projected returns, we can calculate the projected, or expected, risk
premium as the difference between the expected return on a risky investment
and the certain return on a risk-free investment
Suppose risk-free investments are currently offering 8% (i.e., the risk-free rate,
which we label as Rf , is 8%). Given this, what is the projected risk premium on
Stock U? On Stock L?
Expected return on Stock U, E(RU), is 20%; projected risk premium is:
Risk premium  Expected return  Risk-free rate
=E  RU   R f
 20%  8%
 12%
Risk premium on Stock L is 25% - 8% = 17%.

In general, the expected return on a security or other asset is equal to the sum
of the possible returns multiplied by their probabilities.
© McGraw Hill 8-17
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 Portfolio expected returns
Let’s go back to Stocks L and U. You put half your money in each. What is the
pattern of returns on this portfolio? Expected return?
Suppose the economy enters a recession, in which case half your money (the
half in L) loses 20% and the other half (the half in U) gains 30%.
In a recession, portfolio return is: RP = .50 × −20% + .50 × 30% = 5%.
In a boom, portfolio return is: RP = .50 × 70% + .50 × 10% = 40%.
Thus, expected return on your portfolio, E(RP), is 22.5%.
We can calculate the expected return more directly:
E(RP) = .50 × E(RL) + .50 × E(RU)
= .50 × 25% + .50 × 20%
= 22.5%
If we have n assets in our portfolio, where n is any number, and xi stands for
the percentage of our money in Asset i, expected return is:
© McGraw Hill
E  R p   X 1  E  R1   X 2  E  R2   ...  X n  E  Rn  8-18
© McGraw Hill
 The principle of diversification
Figure 13.1 plots the standard
deviation of return versus the
number of stocks in the portfolio.
Notice the benefit in terms of risk
reduction from adding securities
drops off as we add more and more..
Key points:
Principle of diversification implies
some of the riskiness with individual
assets can be eliminated by forming
portfolios.
There is a minimum level of risk that
cannot be eliminated by diversifying
(That is, nondiversifiable risk.

© McGraw Hill
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© McGraw Hill images. 8-19
 Beta and the risk premium 1

Suppose Asset A has an expected return of E(RA) = 20% and a beta of

βA = 1.6. Furthermore, suppose that the risk-free rate is Rf = 8%.
Consider a portfolio made up of Asset A and a risk-free asset. If 25%
of the portfolio is invested in Asset A, then the expected return is:
E(RP) = .25 × E(RA) + (1 − .25) × Rf
= .25 × 20 % + .75 × 8%
= 11%

The beta on the portfolio, βP, would be:

βP = .25 × βA + (1 − .25) × 0
= .25 × 1.6
= .40
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 Beta and the risk premium 2

Is it possible for the percentage invested in Asset A to exceed 100%?

Yes, this happens if the investor borrows at the risk-free rate.
Suppose an investor has $100 and borrows an additional $50 at 8 percent, the
risk-free rate. The total investment in Asset A would be $150, or 150 percent of
the investor’s wealth.
The expected return in this case would be:
E(RP) = 1.50 × E(RA) + (1 − 1.50) × Rf
= 1.50 × 20% − .50 × 8%
= 26%
The beta on the portfolio would be:
βP = 1.50 × βA + (1 − 1.50) × 0
= 1.50 × 1.6
= 2.4

© McGraw Hill 8-21

© McGraw Hill
 The capital asset pricing model 1

Capital asset pricing model (CAPM) is the equation of the SML showing the
relationship between expected return and beta.
Let E(Ri) and βi stand for the expected return and beta, respectively, on any
asset in the market, and the following equation is the C APM:

E  Ri   R f   E  RM   R f   i

CAPM shows the expected return for a particular asset depends on three
things:
1. Pure time value of money: As measured by risk-free rate, Rf, this is the
reward for waiting for your money, without taking any risk.
2. Reward for bearing systematic risk: As measured by the market risk
premium, E(RM) − Rf, this is the reward offered for bearing an average
amount of systematic risk in addition to waiting
3. Amount of systematic risk: As measured by βi, this is the amount of
systematic risk present in a particular asset or portfolio, relative to that
© McGraw Hill in an average asset. 8-22
© McGraw Hill
 Risk and return
Suppose the risk-free rate is 4 percent, the market risk
premium is 8.6 percent, and a particular stock has a beta
of 1.3. Based on the CAPM, what is the expected return
on this stock? What would the expected return be if the
beta were to double?
With a beta of 1.3, the risk premium for the stock is 1.3 ×
8.6 percent, or 11.18 percent. The risk-free rate is 4
percent, so the expected return is 15.18 percent. If the
beta were to double to 2.6, the risk premium would double
to 22.36 percent, so the expected return would be 26.36
percent.

© McGraw Hill 8-23

© McGraw Hill
 The Reward-to-Volatility (Sharpe) Ratio

Investors price risky assets so that the risk premium will be

commensurate with the risk of expected excess returns.
• Best to measure risk by the standard deviation of excess,
not total, returns.
Sharpe ratio.
• Evaluates performance of investment managers.

Risk premium
Sharpe ratio =
SD of excess return

© McGraw Hill 24
 Figure 5.4 The Normal Distribution 2

Figure 5.4 The normal distribution with mean 10% and standard deviation 20%.

Access the text alternative for slide images.

© McGraw Hill 25
 Chapter 8
S T O C K VA L U AT I O N

Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw Hill LLC.
 Growth stocks 1

You might be wondering about shares of stock in companies

such as Alphabet that currently pay no dividends. Small, growing
companies frequently plow back everything and pay no dividends. Are
such shares worth nothing? It depends. When we say that the value of
the stock is equal to the present value of the future dividends, we
don’t rule out the possibility that some number of those dividends are
zero. They just can’t all be zero.
Imagine a company that has a provision in its corporate
charter that prohibits the paying of dividends now or ever. The
corporation never borrows any money, never pays out any money to
stockholders in any form whatsoever, and never sells any assets.
Such a corporation couldn’t really exist because the IRS wouldn’t like
it, and the stockholders could always vote to amend the charter if they
wanted to. If it did exist, however, what would the stock be worth?

© McGraw Hill 8-27

© McGraw Hill
 Growth stocks 2

The stock would be worth absolutely nothing. Such

a company would be a financial “black hole.” Money goes
in, but nothing valuable ever comes out. Because nobody
would ever get any return on this investment, the
investment would have no value. This example is a little
absurd, but it illustrates that when we speak of companies
that don’t pay dividends, what we really mean is that they
are not currently paying dividends.

© McGraw Hill 8-28

© McGraw Hill
 Zero growth
A share of common stock in a company with a constant dividend is much like a
share of preferred stock.
Dividend on a share of preferred stock has zero growth and is constant
through time; for a zero-growth share of common stock, this implies that:
D1  D2  D3  D  Constant
Value of the stock is:
D D D D D
P0       ...
1  R  1  R  1  R  1  R  1  R 
1 2 3 4 5

Stock may be viewed as ordinary perpetuity with cash flow equal to D every
period, with the per-share value given by:

P0  D R

Where R is the required return.

© McGraw Hill 8-29
© McGraw Hill
 Constant growth 1

Suppose we know that the dividend for some company always grows at a
steady rate. Call this growth rate g. If we let D0 be the dividend just paid, then
the next dividend, D1, is:
D1  D0  1  g 

The dividend in two periods is:

D2  D1  1  g 
  D0  1  g   1  g 

 D0  1  g 
2

We could repeat this process to come up with the dividend at any point in the
future.
The dividend t periods into the future, Dt, is given by:

Dt  D0  1  g 
t

© McGraw Hill 8-30

© McGraw Hill
 Constant growth 2

The dividend growth model determines the current price

of a stock as its dividend next period divided by the
discount rate less the dividend growth rate, and can be
written as follows, so long as the growth rate, g, is less
than the discount rate, r:
D0  1  g  D1
P0  
Rg Rg
We can use the dividend growth model to get the stock
price at any point in time; in general, the price of the stock
as of Time t is:
Dt  1  g  Dt  1
Pt  
© McGraw Hill
Rg Rg 8-31
© McGraw Hill
 Constant growth
(concluded)
Suppose D0 is $2.30, R is 13%, and g is 5%. The price per share in this case
is:
P0 = D0 × (1 + g)/(R − g)
= $2.30 × 1.05/(. 13 − . 05 )
= $2.415 / .08
= $30.19
Suppose we are interested in the price of the stock in five years, P5. We first
need the dividend at Time 5, D5. Because the dividend just paid is $2.30 and
the growth rate is 5% per year, D5 is:
D5 = $2.30 × 1.055 = $2.30 × 1.2763 = $2.935
The price of the stock in five years is:

D5  1  g  $2.935  1.05 $3.0822

P5     $38.53
Rg .13  .05 .08

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© McGraw Hill
 Components of the required
return
Earlier, we calculated P0 as: P0 = D1/(R − g). If we rearrange this to solve for R,
we get:
R  g  D1 P0
R  D1 P0  g
Total return, R, has two components:
1. Dividend yield is a stock’s expected cash dividend divided by its current
price (That is, D1/P0).
2. Dividend growth rate, g, can be interpreted as the capital gains yield, the
rate at which the value of an investment grows.
Suppose we observe a stock selling for $20 per share. The next dividend will
be $1 per share. You think that the dividend will grow by 10% per year more or
less indefinitely. What return does this stock offer if this is correct?
R = Dividend yield + Capital gains yield.
R = $1/$20 + .10 = .05 + .10 = .15, or 15%.
© McGraw Hill 8-33
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 Stock valuation using multiples
Obvious problem with dividend-based approach to stock valuation is that
many companies don’t pay dividends.
If the company is profitable (That is, has positive earnings), use the P E ratio,
calculated as the ratio of a stock’s price per share to its earnings per share (E
PS) over the previous year .
Idea is to have some sort of benchmark PE ratio, which we then multiply by
earnings to come up with a price:
Price at Time t  Pt  Benchmark PE ration  EPSt
Benchmark PE ratio could come from a variety of sources (For Example, based
on similar companies, based on a company’s own historical values).
PE ratio based on estimated future earnings is a forward PE ratio.
Some companies do not pay dividends nor are they profitable.
In this case, use the price-sales ratio, calculated as the price per share on the
stock divided by sales per share, or the E V/EBITDA ratio.
© McGraw Hill 8-34
© McGraw Hill
 SUMMARY OF STOCK
VALUATION 1

I.The General Case:

In general, the price today of a share of stock, P0, is the present value of all of
its future dividends, D1, D2, D3, . . . where R is the required return.
D1 D2 D3
P0     .......
1  R  1  R  1  R 
1 2 3

II. Constant Growth Case:

If the dividend grows at a steady rate, g, then the price can be written as:

D1
P0 
Rg

This result is called the dividend growth model.

© McGraw Hill 8-35

© McGraw Hill
 Common stock features:
shareholder rights
Common stock is equity without priority for dividends or in bankruptcy.
Shareholders elect directors who, in turn, hire managers to carry out their
directives.
Directors are elected each year at an annual meeting by a vote of the holders
of a majority of shares who are present and entitled to vote.
In cumulative voting, a shareholder may cast all votes for one member of the
board of directors; all directors are elected at once.
In straight voting, a shareholder may cast all votes for each member of the
board of directors; directors are elected one at a time.
Many companies have staggered elections for directors (That is, classified
boards), but several have been pressured to declassify.
Staggering has two basic effects:

1. Makes it more difficult for a minority to elect a director.

2. Makes takeover attempts less likely to be successful.
© McGraw Hill 8-36
© McGraw Hill
 preferred stock features:
stated value and dividends
Preferred stock has dividend priority over common stock, normally with a
fixed dividend rate, sometimes without voting rights.
Preferred shares have a stated liquidating value, usually $100 per share, with
the cash dividend described in terms of dollars per share.
“$5 preferred” translates into a dividend yield of 5% of stated value.
Preferred dividend is not like interest on a bond.
Board of directors may decide not to pay dividends on preferred share, (which
may have nothing to do with the current net income of the corporation), in
which case:
• Common shareholders must also forgo dividends.
• Holders of preferred shares are often granted voting and other rights if preferred
dividendspayable
Dividends have notonbeen paid forstock
preferred some are
time.either cumulative or noncumulative,
though most are cumulative.
Unpaid preferred dividends are not debts of the firm.
© McGraw Hill 8-37
© McGraw Hill
 preferred stock features:
is preferred stock really debt?
Good case can be made that preferred stock is really debt in disguise, a kind
of equity bond, for the following reasons:
Preferred shareholders receive a stated dividend only.
If corporation is liquidated, preferred shareholders get a stated value .
Preferred stocks often carry credit ratings much like those of bonds.
Preferred stock is sometimes convertible into common stock.
Preferred stocks are often callable .
Many issues of preferred stock have obligatory sinking funds, effectively
creating a final maturity.

In the 1990s, firms began to sell securities that looked a lot like preferred
stocks but were treated as debt for tax purposes, making the interest payments
tax deductible.
Until 2003, interest payments and dividends were taxed at the same marginal
tax rate; when the tax rate on dividend payments was reduced, these
instruments were not included.
© McGraw Hill 8-38
© McGraw Hill
 Stock market reporting:
costco
Price $299.85 is the real-time price of the
last trade.
Reported change is from previous day’s
closing price.
Opening price is first trade of day.
Bid and ask prices of $299.24 and $299.57,
respectively.
Market “depth,” is number of shares sought
at bid price and offered at ask price.
Volume is number of shares traded today.
Market Cap is number of shares
outstanding multiplied by current price per
share.
Yield is reported dividend divided by the
previous stock price: $2.60/$300.84 =
0.86%. Access the text alternative for slide
© McGraw Hill 8-39
© McGraw Hill images.
 End of Main Content

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