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Chapter 8

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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  1. Chapter 8

  2. 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.

  3. 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.

  4. 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.

  5. 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.

  6. 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.

  7. 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.

  8. 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%?

  9. 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

  10. 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%?

  11. D kcs - g Vcs = D1 Vcs k = ( ) + g Expected Return on Common Stock • Just adjust the valuation model

  12. 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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