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Chapter 8

Chapter 8 - Stocks.pdf

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Bruce Everitt

B383 FinanceTues Oct 8 2013 Chapter 8StocksSTOCK VALUATION AND MARKET EFFICIENCYAssets are valued by computing the PV of their future cash flows Equity contract A contract between the firm and an investor that gives the investor a proportion of ownership of the firms assets in exchange for a current paymentShareholders control firm by electing board of directors 1 Election at annual meeting via proxies 2 Directors have fiduciary responsibility to shareholders 3 Directors choose senior management 4 Directors choose whether to pay common dividendsShareholder have a residual claim to firms assetsIntrinsic Value IV o Subjective value o Variety of modelsDividend Discount ModelsTotal Payout ModelRatio Models ie PE MB Market Price MP o Consensus value of all potential tradersTrading Signal o IVMPBuy o IVMPSell or Short Sell o IVMPHold or Fairly PricedInstitutional Features of StocksStock MarketsStocksshares securities issued by incorporated companiesrepresents equityownership so a stockholder is an owner of the company and can control the corporationshare company profitsEach shareholder gets one vote for each share they ownmajority shareholders get more controlAnnual general meeting is where shareholders receive annual financial statements vote on special resolutions and elect members to the BoD Public company shares are traded on a stock exchange sells to the publicPrivate company shares held by limitedof peoplenot actively traded not listed on exchange Primary market market for newly issued shares1 initial public offering IPOfirst becomes a public company and issues stock 2 seasoned offering firm that already has publicly traded stocks sells more sharessecondary market any trading done on the stocks after their initial issuanceTrading Stockslong position for stockbondcommoditycurrency investor owns the security The investor first buys the security and then sells it You take a long position when you expect an increase in asset price because its profitable if you buy at low price and sell at a high priceShort position means investor first sells the asset then buys it back later hopefully at a lower price You take this position in anticipation of a decrease in asset priceMarket order order to buysell thats executed as soon as possible at the best price obtainableLimit order conditional order to buysell Investor specifies a price in the order and the order is filled if the asset pricespecified price or better A limit order to buy is executed at the specified price or lower price A limit order to sell is executed at the specified price or higher price B383 FinanceTues Oct 8 2013Margin amount of money provided by the investorbuying on margin means borrowing to make an investment in stockssecurities So the loan from the broker makes up the total o Brokers are usually restricted to lending no more than half the total value of investmento Investors must provide a margin of at least 50 of the initial cost of a long position Preferred SharesThis is a hybrid instrument because it has characteristics of both common stocks and bondsLike common stock preferred stock doesnt mature and the period paymentsfixed dividends Unlike common stock shareholders preferred stock shareholders dont usually have voting rightsPreferred dividends are paid after bond interest payments but before common stock dividendsCumulative dividends when the BoD elects to suspend preferred dividend payments all skilled dividends must be paid before the firm can ay any common stock dividendsIf the company is liquidated preferred shareholders are entitled to their par value stated value of the security that is not dependent on market value the basis for computingof interest of dividend payments before common shareholders receive anythingPV perpetuityPMTiP Dk where Dperiodic dividend and krequired return of preferred shareholders Preferred Anything that makes the dividend or required return change makes price of preferred share changePrice of preferred share varies inversely with rate of return required by preferred shareholders k o So k varies with LT interest ratesthe perceived risk of the dividend payments being suspendedVALUATION OF COMMON STOCK USING DISCOUNTED CASH FLOWSCommon stock is the main way corporations raise equity or capitalUsually gives the owner one vote per share but sometimes multiplefractional votes different classes of stocksResidual claimants Stockholders are entitled to what is left after all other obligations have been met On liquidation of the firm they receive the liquidation value When there are profits the BoD may distribute them to the stockholders in 2 basic ways 1 Dividends paid usually every quarter on a regular schedule Not an obligation2 Stock repurchases repurchase of stock by a firm from existing stockholders to distribute cash without paying dividends This gives the shareholders the option of selling some shares without reducing their proportionate ownership and thus earning some incomeValuation after Holding Stock for One PeriodTo determine whether current price accurately reflects the forecasted selling price 1 year from now find PV of expected cash flows made of one dividend paymentthe sales price 1 year from now
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