Foundations of Finance Arthur J. Keown John D. Martin J. William Petty David F. Scott, Jr.

1. Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr. Chapter 8 Valuation and Characteristics of Stocks

2. Learning Objectives • Identify the basic characteristics and features of preferred stock. • Value Preferred Stock. • Identify the basic characteristics and features of common stock. Foundations of Finance

3. Learning Objectives • Value common stock. • Calculate a stock’s expected rate of return. Foundations of Finance

4. Principles Used in this Chapter • Principle 1: The Risk-Return Trade-off – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return. • Principle 2: The Time Value of Money – A Dollar Received Today is Worth More Than a Dollar Received in the Future • Principle 3: Cash-Not Profits-Is King. Foundations of Finance

5. Stock • Two types: • Preferred and common Foundations of Finance

6. Preferred Stock • Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock and bonds. • Like common stocks • No fixed maturity date • Failure to pay dividends does not bring on bankruptcy • Dividends are not deductible • Like Bonds • Dividends are for a limited time Foundations of Finance

7. Features of Preferred Stocks • Multiple series of preferred stock • Preferred stock’s claim on assets and income • Cumulative dividends • Protective provisions • Convertibility • Retirement Features Foundations of Finance

8. Multiple Series • If a company desires, it can issue more than one series of preferred stock, and each series can have different characteristics. • Convertible • Protective provisions Foundations of Finance

9. Claim on Assets and Income • Preferred stock has priority over common stock with regard to claim on assets in the case of bankruptcy. • Honored before common stockholders, but after bonds. • Must pay dividends to preferred stockholders before it pays common stockholder dividends. Foundations of Finance

10. Cumulative Dividends • Cumulative features require that all past, unpaid preferred stock dividends be paid before any common stock dividends are declared. Foundations of Finance

11. Protective Provisions • Protective provisions generally allow for voting rights in the event of nonpayment of dividends, or they restrict the payment of common stock dividends if sinking-funds payments are not met or if the firm is in financial difficulty. Foundations of Finance

12. Convertibility • Convertible preferred stock can, at the discretion of the holder, be converted into a predetermined number of shares of common stock. • Almost one-third of preferred issued today is convertible preferred. • Reduces the cost of the preferred stock to the issue Foundations of Finance

13. Retirement Features • Although preferred stock has no set maturity associated with it, issuing firms generally provide for some method of retiring the stock. Foundations of Finance

14. Callable Preferred • A call provision entitles a company to repurchase its preferred stock (or bonds) from their holders at stated prices over a given time period. • Call feature usually involves an initial premium of 10% above par value • Premium declines over time • Allows the issuing firm to plan for the retirement of its preferred stock at predetermined prices. Foundations of Finance

15. Sinking-Fund Provision • Sinking-fund provision requires the firm to set aside an amount of money periodically for the retirement of its preferred stock. • Money used to purchase the preferred stock in the open market or to call the stock, whichever method is cheaper. Foundations of Finance

16. Valuing Preferred Stock • The value of a preferred stock is the present value of all future dividends. • Calculate the value of preferred stock: = Annual dividend / required rate of return Foundations of Finance

17. Valuing Preferred Stock Vps= annual dividend = D required rate of return kps Example: Xerox’s Series C preferred stock pays an annual dividend of $6.25 and the investors required rate of return is 5%. Vps= D = $6.25 = $125.00 kps 0.05 Foundations of Finance

18. Common Stock • Certificate that indicates ownership in a corporation • Common stockholders are the true owners of the firm Foundations of Finance

19. Common Stock • Common stock is a certificate that indicates ownership in a corporation. • Has no maturity date • No upper limit on dividends • Dividend payments must be declared each period (usually quarterly) by the firm’s board of directors. • In the event of bankruptcy, common stockholders will not receive any payment until the creditors, including the bondholders and preferred stockholders, have been satisfied. Foundations of Finance

20. Features of Common Stock • Claim on income • Claim on assets • Voting rights • Preemptive rights • Limited liability Foundations of Finance

21. Claim on Income • Common shareholders have the right to residual income after bondholders and preferred stockholders have been paid. • Can be in the form of dividends or retained earnings. Foundations of Finance

22. Claim on Assets • Common stock has a residual claim on assets after claims of debt holders and preferred stockholders. • If bankruptcy occurs, claims of the common shareholders generally go unsatisfied. Foundations of Finance

23. Voting Rights • Common shareholders are entitled to elect the board of directors • Most often are the only security holders with a vote • Can approve any change in the corporate charter Foundations of Finance

24. Voting Rights • Voting for directors and charter changes occur at the corporation’s annual meeting. • A proxy gives a designated party the temporary power of attorney to vote for the signee at the corporation’s annual meeting. • Proxy fights - battles between rival groups for proxy votes. • Cumulative voting - each share of stock allows the stockholder a number of votes equal to the number of directors being elected. Foundations of Finance

25. Preemptive Rights • Preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the firm. • Rights - certificates issued to the shareholders giving them an option to purchase a stated number of new shares of stock at a specified price during a two- to ten-week period. Foundations of Finance

26. Limited Liability • Liability of the shareholder is limited to the amount of their investment. • Limited liability feature aids the firm in raising funds. Foundations of Finance

27. Valuing Common Stock • Two Methods: • Present value of all future dividends • Free cash flow method Foundations of Finance

28. Present Value of Future Dividends • Growth factor • Infusion of capital • Financing, debt, common stock • Internal growth • Management retains some or all of the firm’s profits for reinvestment in the firm Foundations of Finance

29. Internal Growth g= ROE x r Whereg = the growth rate of future earnings and the growth in the common stockholder’s investment in the firm ROE = the return on equity (net income/common book value) r = the company’s percentage of profits retained - profit retention rate Foundations of Finance

30. Valuing of Common Stock • Dividend Valuation Method: Common stock value = • dividend in year 1 / (required rate of return – growth rate) Foundations of Finance

31. Valuing Common Stock Consider the valuation of a common stock that paid $2.00 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 10% and the investors required rate of return is 15%. Foundations of Finance

32. Valuing Common Stock • The dividend last year was $2. Compute the new dividend by: D1 = D0(1+g) = $2(1+.10)=$2.20 2. Vcs= D1/ (kcs – g) = $2.20/(.15-.10) = $44 Foundations of Finance

33. Valuing Common Stock • Free Cash Flow Method: Shareholder value = firm value – debt / number of shares outstanding • Where firm value is the present value of free cash flows discounted a the company’s cost of capital Foundations of Finance

34. Expected Rate of Return • The expected rate of return on a security is the required rate of return of investors who are willing to pay the market price for the security. • Preferred Stock Expected Return: • Annual dividend/market price • Common Stock Expected Return • (Dividend in year 1 / market price) + dividend growth rate Foundations of Finance