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Department

Finance

Course Code

FIN 3310

Professor

Lifeixue

Chapter

8

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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