Chapter 8
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Chapter 8. Security Valuation. In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. Preferred Stock. A hybrid security : it’s like common stock - no fixed maturity.

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Chapter 8

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Chapter 8

Chapter 8


Security valuation

Security Valuation

  • In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.


Preferred stock

Preferred Stock

A hybrid security:

  • it’s like common stock - no fixed maturity.

    • technically, it’s part of equity capital.

  • it’s like debt - preferred dividends are fixed.

    • missing a preferred dividend does not constitute default, but preferred dividends are cumulative.


Chapter 8

Preferred Stock

  • Usually sold for $25, $50, or $100 per share.

  • Dividends are often quoted as a percentage of par.

    • Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share.

    • $4.125 is the fixed, annual dividend per share.


Common stock

Common Stock

  • is a variable-income security.

    • dividends may be increased or decreased, depending on earnings.

  • represents equity or ownership.

  • includes voting rights.

  • Priority: lower than debt and preferred.


Common stock characteristics

Common Stock Characteristics

  • Claim on Income - a stockholder has a claim on the firm’s residual income.

  • Claim on Assets - a stockholder has a residual claim on the firm’s assets in case of liquidation.

  • Preemptive Rights - stockholders may share proportionally in any new stock issues.

  • Voting Rights - right to vote for the firm’s board of directors.


Chapter 8

D1

kcs - g

Vcs =

  • Constant Growth Model

  • Assumes common stock dividends will grow at a constant rate into the future.

  • D1 = the dividend at the end of period 1.

  • kcs= the required return on the common stock.

  • g = the constant, annual dividend growth rate.


Example

Example

  • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?


Example1

Example

  • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

D0 = $5, so D1 = 5 (1.10) = $5.50


Example2

D1 5.50

kcs - g .15 - .10

Vcs = = = $110

Example

  • XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?


Expected return on common stock

D

kcs - g

Vcs =

D1

Vcs

k = ( ) + g

Expected Return on Common Stock

  • Just adjust the valuation model


Example3

D1

Po

kcs = ( ) + g

kcs = ( ) + .05 = 16.11%

3.00

27

Example

  • We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%.


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