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Chapter 8

FIN 3310 Chapter 8: Chapter 8
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2 Pages
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Spring 2017

Department
Finance
Course Code
FIN 3310
Professor
Lifeixue
Chapter
8

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Chapter 8
Tuesday, March 21, 2017
10:59 AM
Common stock valuation
o A share of common stock is more difficult to value in practice than a bond for at
least three reasons.
1. With common stock, 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
Ex: if you buy stock today and sell it at the end of the year, you will have a total
of $80 id cash. At 15 percent:
Present value = ($10 + 70)/ 1.25 = $64.00
Therefore, $64 is the value you would assign to the stock today
o Note that no matter what the stock price is, the present value is essentially zero if
we push the sale of the stock far enough away
Zero growth
o A share of common stock in a company with a constant dividend is much like a share
of preferred stock
The dividend on a share of preferred stock has zero growth and thus is
constant through time
D1 = D2 = D3 = D = constant
o Because the dividend is always the same, the stock can be viewed as an ordinary
perpetuity with a cash flow equal to D every period
P = D/R where R is the required return
o If the dividend grows at a steady rate, then we replaced the problem of forecasting
an infinite number of future dividends with the problem of coming up with a single
growth rate
P0 = D0 x (1+g)/ R- g = D1/ R - g
Components of the required return
o If we arrange the formula above we get R= D1/P0 + g
This tells us that the total return, R, has two components
The first of these, D1/P0, is called the dividend yield
Is calculated as the expected cash dividend by the current price
o The second part of the total return is the growth rate, g.
This growth rate can be interpreted as the capital gains yield
The rate at which the value of the investment grows
o R = Dividend yield + Capital gains yield
Common stock features
o Shareholder rights
The conceptual structure of the corporation assumes that shareholders elect
directors who hire managers to carry out their directives
Only shareholders have this right
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Description
Chapter 8 Tuesday, March 21, 2017 10:59 AM • Common stock valuation o A share of common stock is more difficult to value in practice than a bond for at least three reasons. 1. With common stock, 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 ▪ Ex: if you buy stock today and sell it at the end of the year, you will have a total of $80 id cash. At 15 percent: • Present value = ($10 + 70)/ 1.25 = $64.00 • Therefore, $64 is the value you would assign to the stock today o Note that no matter what the stock price is, the present value is essentially zero if we push the sale of the stock far enough away • Zero growth o A share of common stock in a company with a constant dividend is much like a share of preferred stock ▪ The dividend on a share of preferred stock has zero growth and thus is constant through time • D1 = D2 = D3 = D = constant o Because the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period ▪ P = D/R where R is the required return o If the dividend grows at a steady rate, then we replaced the problem of forecasting an infinite number of future dividends with the problem of coming up with a single growth rate ▪ P0 = D0 x (1+g)/ R- g = D1/ R - g • Components of the required return o If we arrange the formula above we get R= D1/P0 + g ▪ This tells us that the total return, R, has two components ▪ The first of these, D1/P0, is called the dividend yield • Is calculated as the expected cash dividend by the current price o The second part of the total return is the growth rate, g. ▪ This growth rate can be interpreted as the capital gains
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