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CHAPTER 7

CHAPTER 7. Stocks, Stock Valuation, and Stock Market Equilibrium. Topics in Chapter. Features of common stock Valuing common stock Preferred stock. Common Stock: Owners, Directors, and Managers. Represents ownership. Ownership implies control. Stockholders elect directors.

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CHAPTER 7

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  1. CHAPTER 7 Stocks, Stock Valuation, and Stock Market Equilibrium

  2. Topics in Chapter Features of common stock Valuing common stock Preferred stock

  3. Common Stock: Owners, Directors, and Managers Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of shareholders, their goal should be: Maximize stock price.

  4. Different Approaches for Valuing Common Stock Dividend growth model Constant growth stocks Non-constant growth stocks Free cash flow method (covered in Chapter 11)

  5. Stock Value = PV of Dividends D1 D2 D3 D∞ ^ P0 = + + … + + (1 + rs)1 (1 + rs)2 (1 + rs)3 (1 + rs)∞ What is a constant growth stock? One whose dividends are expected to grow forever at a constant rate, g.

  6. For a constant growth stock: D1 = D0(1 + g)1 D2 = D0(1 + g)2 Dt = D0(1 + g)t If g is constant and less than rs, then: D0(1 + g) D1 ^ P0 = = rs – g rs – g

  7. Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%. Use the CAPM to calculate rs: rs = rRF + (RPM)bFirm = 7% + (5%)(1.2) = 13%.

  8. Projected Dividends Suppose D0= $2 and constant g = 6% D1 = D0(1 + g) = $2(1.06) = $2.12 D2 = D1(1 + g) = $2.12(1.06) = $2.2472 D3 = D2(1 + g) = $2.2472(1.06) = $2.3820

  9. Intrinsic Stock Value: D0 = $2.00, rs = 13%, g = 6% Constant growth model: ^ D0(1 + g) D1 P0 = = rs – g rs – g $2.12 $2.12 = = = $30.29. 0.13 – 0.06 0.07

  10. Expected price one year from now: D1 will have been paid, so expected dividends are D2, D3, D4 and so on. D2 ^ $2.2472 P1 = = = $32.10 rs – g 0.07

  11. Expected Dividend Yield and Capital Gains Yield (Year 1) D1 $2.12 Dividend yield = = = 7.0%. P0 $30.29 ^ P1 – P0 $32.10 – $30.29 CG Yield = = P0 $30.29 = 6.0%.

  12. Total Year 1 Return Total return = Dividend yield + Capital gains yield. Total return = 7% + 6% = 13%.

  13. Rearrange model to rate of return form: D1 D1 ^ ^ P0 = to rs + g. = rs – g P0 ^ Then, rs = $2.12/$30.29 + 0.06 = 0.07 + 0.06 = 13%.

  14. If g = 0, the dividend stream is a perpetuity. 0 1 2 3 rs = 13% 2.00 2.00 2.00 PMT $2.00 ^ P0 = = = $15.38. r 0.13

  15. Non-constant Growth Stock Non-constant growth of 30% for Year 0 to Year 1, 25% for Year 1 to Year 2, 15% for Year 2 to Year 3, and then long-run constant g = 6%. Can no longer use constant growth model for the first 3 years. However, growth becomes constant after 3 years.

  16. Example 1: Nonconstantgrowth followed by constant growth (D0 = $2): 0 1 2 3 4 rs = 13% g = 30% g = 25% g = 15% g = 6% 2.6000 3.2500 3.7375 3.9618 2.3009 2.5452 2.5903 $3.9618 ^ = $56.5971 P3 = 39.2246 0.13 – 0.06 ^ 46.6610 = P0

  17. Example 2: suppose g = 0 for t = 1 to 3, and then g is a constant 6%. 0 1 2 3 4 rs = 13% g = 0% g = 0% g = 0% g = 6% 2.00 2.00 2.00 2.12 1.7699 1.5663 1.3861 2.12 = = P 30.2857 20.9895 0.07 3 25.7118 ^

  18. Example 2 (continued) Dividend Yield = D1/P0 = $2.00/$25.72 = 7.8% CGY = 13.0% – 7.8% = 5.2%.

  19. Preferred Stock - perpetuity Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.

  20. Expected return, given P = $50 and annual dividend = $5 $5 Pps = $50 = ^ rps $5 ^ rps = = 0.10 = 10.0% $50

  21. Market Efficiency For most stocks, for most of the time, it is generally safe to assume that the market is reasonably efficient. However, periodically major shifts can and do occur, causing most stocks to move strongly up or down.

  22. Homework Assignment Problems: 1,2,3,4,5,6,7,8,11,12,13,14, 18(a,b,c)

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