Chapter 8

Security Valuation n 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.

Preferred Stock A hybrid security: n it’s like common stock - no fixed maturity. u technically, it’s part of equity capital. n it’s like debt - preferred dividends are fixed. u missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

n Usually sold for $25, $50, or $100 per share. n Dividends are often quoted as a percentage of par. u Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. u $4.125 is the fixed, annual dividend per share. Preferred Stock

Common Stock n is a variable-income security. u dividends may be increased or decreased, depending on earnings. n represents equity or ownership. n includes voting rights. n Priority: lower than debt and preferred.

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

n Constant Growth Model n Assumes common stock dividends will grow at a constant rate into the future. n D 1 = the dividend at the end of period 1. n k cs = the required return on the common stock. n g = the constant, annual dividend growth rate. V cs = D 1 k cs - g

Example n XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%?

Example n XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? D 0 = $5, so D 1 = 5 (1.10) = $5.50

Example n XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? V cs = = = $110 D k cs - g

Expected Return on Common Stock n Just adjust the valuation model V cs = D k cs - g k = ( ) + g D 1 V cs

Example n We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%. k cs = ( ) + g D1PoD1Po k cs = ( ) +.05 = 16.11%