Finance and Investment

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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
Before investing any money, what five things should Marcellino do first?
Is Marcellino’s strategy for investing in an oil exploration stock to make quick profits investing
or speculating? Support your answer.
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?”
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)
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?
What other financial risks does Marcellino face if he invests in an exploration stock?
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?
Luc has urged Marcellino to invest for the long term using a diversified approach. Marcellino is
skeptical. Explain why Luc is probably correct.
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?”
Using the information provided, calculate the stock’s P/E ratio. Would you classify this
investment as a growth or value 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.
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?
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 “nolose guarantee.” Should they invest with this type of broker?
Name at least five things Pete & Jessica need to look out for when making stock investments.
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.
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?
Develop a checklist of rules that Miguel should use when purchasing a bond.
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?
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
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.

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