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MGFB10H3 (19)
Chapter 7

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University of Toronto Scarborough
Sultan Ahmed

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
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