1. Chapter 4 Valuation of Bonds  2005, Pearson Prentice Hall

2. 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.

3. Preferred Stock A hybrid security: It’s like common stock - no fixed maturity. –Technically, it’s part of equity capital. It’s like debt - preferred dividends are fixed. –Missing a preferred dividend does not constitute default, but preferred dividends are cumulative.

4. 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

5. Firms may have multiple classes of preferreds, 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

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

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

8. Preferred Stock Valuation A preferred stock can usually be valued like a perpetuity: V = D k ps

9. 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 = 4.125.095.095 = $43.42

10. Expected Rate of Return on Preferred Just adjust the valuation model: DPoDPo k ps =

11. Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: DPoDPo k ps = = =.1031 4.125 40

12. The Financial Pages: Preferred Stocks 52 weeks Yld Vol Hi Lo Sym Div % PE 100s Close 27 88 25 06 GenMotor pfG 2.28 8.9 … 86 25 53 Dividend: $2.28 on $25 par value = 9.12% dividend rate. Expected return: 2.28 / 25.53 = 8.9%.

13. Common Stock Is a variable-income security. –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.

14. 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.

15. 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 ? 5.50 + 120

16. Common Stock Valuation (Single Holding Period) Solution: Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $109.13

17. Common Stock Valuation (Single Holding Period) Financial Calculator solution: P/Y =1, I = 15, n=1, FV= 125.50 solve: PV = -109.13 or: P/Y =1, I = 15, n=1, FV= 120, PMT = 5.50 solve: PV = -109.13

18. The Financial Pages: Common Stocks 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 135 80 IBM.52.5 21 142349 99 93 94 96 -3 43 82 18 CiscoSys … 47 1189057 21 19 20 25 -1 13

19. Common Stock Valuation (Multiple Holding Periods) Constant Growth Model Assumes common stock dividends will grow at a constant rate into the future. V cs = D 1 k cs - g

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

21. Example 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

22. Example 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 1 5.50 k cs - g.15 -.10

23. Expected Return on Common Stock Just adjust the valuation model V cs = D k cs - g k = ( ) + g D1PoD1Po

24. Example 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% 3.00 27