Textbook Notes
(363,237)

Canada
(158,278)

University of Toronto Scarborough
(18,341)

Finance
(37)

MGFB10H3
(19)

Sultan Ahmed
(8)

Chapter 7

# Chapter 7.docx

by
OneClass3113

Unlock Document

University of Toronto Scarborough

Finance

MGFB10H3

Sultan Ahmed

Winter

Description

Chapter 7: Equity Valuation
7.1 Equity Securities
Equity Securities: ownership interests in an underlying entity usually a corporation (E.g.
common shares)
o No fixed maturity date
o Equities pay dividends from after-tax earnings so unlike interest payments, they do not
provide the issuer w/ tax deductible expense
Common shareholders can exert control the corporation through their power to vote which
allows them to elect the board of directors and to vote on major issues (e.g. takeovers)
o E.g. a purchaser of 200 CS owns (200/n *100) percent of the corporation
Most preferred shares (PS)have preference over common shares w/ respect to income and
assets (in the event of liquidation) but they rarely have any voting rights
PS does not have a fixed maturity date but pay dividends of a fixed amount at regular intervals
indefinitely whereas bonds do have a maturity date
o Difference b/w bonds and PS: interest payments are obligatory and shares are only
obligatory when they have been declared
Valuation of Equity Securities:
We estimate the expected future cash flows associated w/ the security and then determine the
discounted present value of those future cash flows based on an appropriate discount rate (k)
The discount rate for equities will equal the risk-free rate of return plus a risk premium (like
bonds):
o K= RF + Risk Premium
o K= the required return on an equity security, RF= the risk-free rate of return
Risk-free rate comprises the real rate of return plus expected inflation
Risk premium will be based on an estimate of the risk associated w/ security (higher the risk,
higher the premium)
Along w/ the discount rate, investors must estimate the size and timing of the expected cash
flows associated w/ n equity security
7.2 Preferred Share Valuation
B/c preferred shares dividend payments are indefinite, we can call these investments
“perpetuities” P ps the market price (present value), D ispthe dividend amount or payment, k is thp required
rate of return on preferred shares (discount rate)
In practice, dividends are paid quarterly
Preferred shares will trade at par when the dividend rate equals the market rate, at a discount
from par when market rates exceed the dividend rate and at premium when market rates are
less than the dividend rate
7.3 Common Share Valuation: The Dividend Discount Model (DDM)
The Basic Dividend Discount Model:
We must make estimate regarding the amount and timing of any dividend payments
Dividend Discount Model (DDM): a model for valuing common shares that assumes they are
valued according to the present value of their expected future dividends
P 0 estimated share price today, D =1the expected divided at the end of year 1, P = tne expected
share price after n years, k = the required rate on the common shares
c
The price today is the present value of all future dividends to be received (i.e. from now to
infinity). Therefore, formula is:
The value of a share is the present value of expected future dividends
By repeatedly substituting for the share price, we are implicitly making a very important
assumption: that investors are rational o We assume that at each pt, investors react rationally and value the share based on what
they rationally expect to receive the next yr
The Constant Growth DDM:
Assuming that dividends grow at a constant rate (g) indefinitely, we can estimate all future
dividends
o Assuming we know that the last dividend paid (D0)
Constant Growth DDM: a version of the dividend discount model for valuing common shares,
which assumes that dividends grow at a constant rate indefinitely
Regarding this formula:
o This relationship holds only when c is greater than g. Otherwise, the answer is negative
which is uninformative
o Only future estimated cash flows and estimated growth in these cash flows are relevant
o The relationship holds only when growth in dividends is expected to occur at the same
rate indefinitely
Estimating the Required rate of Return:
The rate of return for Constant Growth DDM is:
Rate of Return= Dividend Yield + Capital Gains Yield
o Dividend yield= D1/P0, Capital gains= g
Estimating the Value of Growth Opportunities:
The Constant Growth DDM can provide a useful assessment of the market’s perception of
growth opportunities available to a company as reflected in its market place No growth component= EPS /k 1ndcgrowth opportunities= PVGO
Growth opportunities generally represent a company’s ability to generate substantial growth in
future profits and cash flows
Examining the Inputs of the Constant Growth DDM:
The price of common shares (P )0will increase as a result of
o An increase in D1
o An increase in g
o A decrease in k
c
DDM links common share prices to 1) corporate profitability, 2) general level of i

More
Less
Related notes for MGFB10H3