Textbook Notes (368,552)
Canada (161,962)
Commerce (1,696)


4 Pages
Unlock Document

Kevin Brewer

Commerce 2FA3 Chapter 8: Stock Valuation - A common stock is more difficult to value than a bond for the following 3 reasons: 1) Not even the promised cash flows are known in advance 2) The life of the investment is essentially forever because common stock has no maturity 3) There is no way to easily observe the rate of return that the market requires Common Stock Cash Flows Let Po be the current price of the stock, and define P1 to be the price in one period. If D1 is the cash dividend paid at the end of the period then, Po= (D1+P1) / (1+r) Common Stock Valuation: Some Special Cases 3 cases 1) Zero Growth - The dividend has a zero growth rate - Implies: D1 = D2 = D3 = D =constant - Value of the stock: Po= D/(1+r)^n + … - Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period - The per-share value: Po= D/r r- the required return 2) Constant Growth -D1=Do X (1+g) The dividend in 2 periods: D2=D1 X (1+g) = Do X (1+g)^2 General formula: Dt= Do X (1+g)^t If the dividend grows at a steady rate, g, the price can be written as: Po= D1/(r-g) 3) Non-constant growth - To avoid the problem of having to forecast and discount an infinite number of dividends, we require that the dividends start growing at a constant rate sometime in the future Changing the Growth Rate - The cases are infinite - Supernormal growth: Pt= Dt X (1+g)/(r-g) t- number of periods Components of the Required Return r = D1/Po + g r= Dividend yield + Capital gains yield r- total return 2 components 1) Dividend Yield (numerator): A stock’s cash dividend divided by its current price 2) Capital gains yield (g): The dividend growth rate or the rate at which the value of an investment grows Common Stock Features Common Stock: Equity without priority for dividends or in bankruptcy Shareholder’s Rights - Structure of the corporation assumes that shareholders elect directors who hire management to carry out their directives - Shareholders control the corporation through their right to elect the directors  Only shareholders have this right Other Rights - The value of share of common stock in a corporation is directly related to the general rights of shareholders - In addition to the right to vote for directors, shareholders usually have the following rights: 1) The right to share proportionally in dividends paid 2) The right to share proportionally in assets remaining after liabilities have been paid in a liquidation 3) The right to vote on stockholder matters of great importance, such as a merger, usually done at the annual meeting or a special meeting - Stockholders sometime have the right to share proportionally in any new stock sold  Preemptive right - Means that a company wishing to sell stock must first offer it to the existing stockholders before offering it to the general public - The purpose is to give a stockholder the opportunity to protect his or her proportionate ownership in the corporation Dividends - Return on capital of corporation paid by company to shareholders in either cash or stock - The payment of dividends is at the discretion of the board of directors Some important characteristics of dividends include the following: 1) Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation - A corporation cannot default on an undeclared dividend 2) The payment of dividends by the corporation is not a business expense - Are not deductible for corporate tax purposes - Are paid out of after-tax profits of the corporation 3) Dividends received by individual shareholders are partially sheltered by a dividend tax credit - Corporations that owns tock in other corporations are permitted to exclude 100 percent of the dividend amounts they receive from taxable Canadian corporations Classes of Stock - The classes are created with unequal voting rights - A primary reason of creating dual classes of stock has to do with control of the firm Preferred Stock Features Preferred Stock: Stock with dividend priority over common stock, normally with a fixed dividend rate, often without voting rights - Preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation - Preference means the holders of the preferred shares must receive a dividend before holders of common shares are entitled to anything - If the firm is liquidated, preferred shareholders rank behind all creditors but ahead of common shareholders - A form of equity from a legal, tax, and regulatory standpoint - Holders have no voting rights Stated Value - A stated liquidating value Cumulative and Non-Cumulative Dividends - Dividends payable on preferred stock are either cumulative or non-cumulative, most are cumulative - If preferred dividends are cumulative and are not paid in a particular year, they are carried forward as an arrearage - Both the cumulative (past) preferred dividends plus the current preferred dividends must be paid before the common shareholders can receive anything - Unpaid dividends are not debt of the firm - Directors elected by the common shareholders can defer preferred dividends indefinitely 1) Common shareholders must also forgo dividends 2) Holders of preferred shares are often granted voting and other rights if preferred dividends have not been paid for some time Is Preferred Stock Really Debt? - Received a stated dividend only, and if the corporation is liquidated, preferred shareholders get a stated value - Is sometimes convertible into common stock - Are often callable by the issuer and the holder often has the right to sell the preferred stock back to the issuer at a set price Preferred Stock and Taxes - A tax loophole encourages corporations that are lightly taxed or not taxable due to losses or tax shelters to issue preferred stock Beyond Taxes - For fully taxed firms, the fact that dividends are not an allowable deduction from taxable corporate income is the most serious obstacle to issuing preferred stock - Firms issuing preferred stock concerns control the firm - Corporations own most preferred stock - Corporate income from preferred stock dividends enjoys a tax exemption, which can substantially reduce the ta disadvantage of preferred stock Growth Opportunities - EPS=Div EPS Earnings per share Div Dividends per shar
More Less

Related notes for COMMERCE 2FA3

Log In


Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.