CGA Finance 1

Learning objectives Explain the general determinants of common share prices. Define and show the relationships between (a) the current price of a security, (b) the expected rate of return on the security ( E(r)), and ( c) the required rate of return on the security ( r). Define the risk of an equity security for one stock and multi stock portfolios. Compute the statistical measures of variability: variance, standard deviation, and correlation( 协相关 ). Explain how risk measures for equity securities are used to arrive at a required rate of return.

CGA Finance 1 Learning objectives (Cont’d) Use a procedure for calculating a risk premium for common shares. Explain the Capital Asset Pricing Model ( CAPM) approach to risk assessment, and the concept of risk reduction through diversification.

CGA Finance 1 Key terms (1) Key terms (1) Chapter 6  Asset allocation ( 在投资组合中的 ) 资产分配  Beta 贝他系数  Capital asset pricing model (CAPM) 资本资产定价模型  Characteristic line 特征线  Expected rate of return 期望收益率  Firm-specific risk or company-unique risk : 企业个体风险  Diversifiable risk or unsystematic risk: 可分散的或非系统 性风险  Investor’s required rate of return: 投资者所要求的收益率

CGA Finance 1 Key terms (2) Key terms (2) Chapter 6  Market-related risk ( nondiversifiable risk or systematic risk) 与市场有 关的风险 ( 不可分散的风险或系统性风险 )  Opportunity cost of funds 资金机会成本  Portfolio beta 投资组合的贝他系数  Real rate of interest 实际利率  Risk 风险  Risk-free or riskless rate of return 无风险收益率  Risk Premium 风险溢价  Security market line 证券市场线  Standard deviation ( σ) 标准差  variance ( σ 2 ) 方差  Term structure of interest rates 利率期限结构

CGA Finance 1  2005, Pearson Prentice Hall Objective 1 - Stock Valuation Required reading: Chapter 8 Stock valuation

CGA Finance 1 1 Security Valuation In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

CGA Finance Preferred Stock A hybrid security: It ’ s like common stock - no fixed obligationmaturity. –Technically, it ’ s part of equity capital. It ’ s like debt fixed. –Missing a preferred dividend does not constitute default, but preferred dividends are cumulative, and should be paid befor the common dividends.

CGA Finance 1 1 Usually sold for $25, $50, or $100 per share. Dividends are fixed either as a dollar amount or as a percentage of par value. Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. –$4.125 is the fixed, annual dividend per share. Preferred Stock

CGA Finance 1 1 Firms may have multiple classes of preferred shares, each with different features. Priority: lower than debt, higher than common stock. Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared. Preferred Stock Features

CGA Finance 1 1 Protective provisions are common. Convertibility: many preferred shares are convertible into common shares. Adjustable rate preferred shares have dividends tied to interest rates. Participation: some (very few) preferreds have dividends tied to the firm ’ s earnings. Preferred Stock Features

CGA Finance 1 1 PIK Preferred: Pay-in-kind preferred stocks pay additional preferred shares to investors rather than cash dividends. Retirement: Most preferred shares are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares. Preferred Stock Features

CGA Finance 1 1 Preferred Stock Valuation A preferred stock can usually be valued like a perpetuity: V = D k ps

CGA Finance 1 1 Example: Xerox preferred pays an 8.25% dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%. V ps = = $43.42

CGA Finance 1 1 Expected Rate of Return on Preferred Just adjust the valuation model: DPoDPo k ps =

CGA Finance 1 1 Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, compute the expected return of preferred stock. What would happen if the expected rate return is not equal to the required rate of return?

CGA Finance 1 1 Question What would happen if the expected rate return is not equal to the required rate of return?

CGA Finance 1 1 The Financial Pages: Preferred Stocks 52 weeks Vol Hi Lo Sym Div % PE 100s Close GenMotor pfG … Dividend: $2.28 on $25 par value = 9.12% dividend rate. Expected return: 2.28 / = 8.9%.

CGA Finance Common Stock Is a variable-income security.( Residual claim) –Dividends may be increased or decreased, depending on earnings. Represents equity or ownership. Includes voting rights. Limited liability: liability is limited to amount of owners ’ investment. Priority: lower than debt and preferred.

CGA Finance 1 1 Common Stock Characteristics Claim on Income - a stockholder has a claim on the firm ’ s residual income. Claim on Assets - a stockholder has a residual claim on the firm ’ s assets in case of liquidation. Preemptive Rights - stockholders may share proportionally in any new stock issues. Voting Rights - right to vote for the firm ’ s board of directors.

CGA Finance 1 1 You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time. If you require a 15% rate of return, what would you pay for the stock now? Common Stock Valuation (Single Holding Period) 0 1 ?

CGA Finance 1 1 Common Stock Valuation (Single Holding Period) Solution: Vcs = D 1 / (1+r) + P 1 / (1+r) = (5.50/1.15) + (120/1.15) = = $109.13

CGA Finance 1 1 E (r) = (D 1 + P 1 )/ P 0 – 1 = D1/ P0 + (P1-P0)/P0 E( r) : the expected return from t=0 to t =1 D 1 : the expected dividend at t=1 P 1 : the expected stock price at t=1 P 0 : the current stock price at t=0 Expected rate of return on common stock (Single Holding Period)

CGA Finance Assume the current price of the stock is $108,other information remain unchanged in the last example. requirement: (1) compute the Expected return rate. (2) with the result of expected return rate, what decision do the rational investors would make? 2. Example 5-1 (LN 5) Example