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© 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 6: Common Shares: Characteristics and Valuation
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© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction This chapter describes: the characteristics of common shares common share valuation models
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© 2004 by Nelson, a division of Thomson Canada Limited 3 Common Shares Common shares are evidence of ownership. Common shareholders own the firm. Common shares are a form of long-term financing for a firm. Common shares are often called a residual security as their value represents whatever assets are left after all prior claims against the assets have been settled. Common shareholders elect the Board of Directors.
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© 2004 by Nelson, a division of Thomson Canada Limited 4 Balance Sheet Accounts Par Value of Common Shares (can ignore for all practical purposes) Contributed Capital in Excess of Par Additional paid in capital Capital surplus Retained earnings
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© 2004 by Nelson, a division of Thomson Canada Limited 5 Book Value per Share The book value of a company’s assets attributable to each share of common stock Example: ZBC Corporation reports a common share account balance of $10M and a retained earnings of $5M with 100M shares outstanding. The book value per share is $0.15.
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© 2004 by Nelson, a division of Thomson Canada Limited 6 Common Shareholder Rights Right to vote at shareholder meetings. Right to share in the profits of an organization (paid either as a dividend or as reinvested profits). Right to share in the residual assets of an organization after all other stakeholder (i.e. governments, creditors, employees) claims are satisfied.
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© 2004 by Nelson, a division of Thomson Canada Limited 7 Voting for the Board of Directors Majority voting Each share carries one vote Requires more than 50% of the votes to elect a Director Cumulative voting Each share carries as many votes as there are Directors to be elected Shareholders may cast all votes for one candidate
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© 2004 by Nelson, a division of Thomson Canada Limited 8 Voting by Proxy Shareholders may elect to assign their voting rights to someone else. Management actively solicits proxies. A dissent shareholder group may attempt to solicit proxies to wrest control away from management.
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© 2004 by Nelson, a division of Thomson Canada Limited 9 Common Share Features Certificate of ownership Classes Voting vs. non-voting Amount shareholder invests in common shares is the maximum capital at risk (shares are said to be “fully paid and non-assessable”). Common shares are marketable securities that can be transferred from one investor to another.
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© 2004 by Nelson, a division of Thomson Canada Limited 10 Common Share Features Advantages Flexible Reduces financial risk Disadvantages Dilute Earnings Per Share Most expensive form of financing
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© 2004 by Nelson, a division of Thomson Canada Limited 11 Common Share Transactions Cash Dividend Firm pays a portion of retained earnings in cash to shareholders based upon number of shares owned (i.e. $0.60/share) Stock Dividend Funds transferred from retained earnings to the common share account. Shareholders receive certificate for additional shares.
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© 2004 by Nelson, a division of Thomson Canada Limited 12 Common Share Transactions Stock Split Firm increases the number of shares outstanding by issuing a specific number of new shares for every old shares outstanding Example: stock splits 3 for 1. Reverse Stock Split Firm decreases the number of shares outstanding by consolidating a specific number of old shares into one share. Example: stock reverse split of 1 for 3
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© 2004 by Nelson, a division of Thomson Canada Limited 13 Common Share Transactions Stock Repurchases Disposition of excess cash Repurchased shares are often cancelled Earnings power of remaining shares is increased Financial restructuring Future corporate needs (stock option plans) Reduction of takeover risk
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© 2004 by Nelson, a division of Thomson Canada Limited 14 Valuation of Common Shares Cash flows attributable to a common stock accrue from: Dividend stream (while owning the stock) Sale price (the future dividends that would have been received from sale date to perpetuity) The market value of a common stock is equal to the present value of its expected future cash flows!
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© 2004 by Nelson, a division of Thomson Canada Limited 15 Dividend Valuation Models Zero growth model Constant growth model Nonconstant growth model
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© 2004 by Nelson, a division of Thomson Canada Limited 16 Dividend Valuation Models Zero Growth Model The cash flow (dividend) is expected to remain the same over time. Identical to model applied to preferred shares D = Dividend at time period 1 k = Required Rate of Return
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© 2004 by Nelson, a division of Thomson Canada Limited 17 Zero Growth: Example Firm ABC currently pays a dividend of $1.00 per share. This is expected to remain the same into the foreseeable future. If shareholders require a return of 20% to hold the stock, what is each share worth in the market?
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© 2004 by Nelson, a division of Thomson Canada Limited 18 Dividend Valuation Models Constant Growth Model The cash flow (dividend) is expected to increase at a constant rate over time D 1 = Dividend in Next Period [D 1 = D 0 x (1+g)] k = Required Rate of Return g = constant growth rate
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© 2004 by Nelson, a division of Thomson Canada Limited 19 Constant Growth: Example Yesterday, Tinkerbell Corporation paid a dividend of $1.00 per share. The dividend is expected to grow at a rate of 5% per year for the foreseeable future. If the shareholders require a 15% return to hold Tinkerbell shares, what is each share worth in the market?
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© 2004 by Nelson, a division of Thomson Canada Limited 20 Dividend Valuation Models Nonconstant Growth Model Many firms grow rapidly for period of time. However, eventually, growth slows to a long- run sustainable constant rate To deal with the nonconstant growth example, we simply present value all dividends back to time period zero
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© 2004 by Nelson, a division of Thomson Canada Limited 21 Nonconstant Growth: Example Tiny Toys Inc. is a new firm that is expected to grow at a 20% rate for 3 years. From then on, growth is expected to be 10% per year. The firm paid a dividend of $1.00 yesterday. The dividend is expected to grow at the same rate as the firm’s growth rate. If the shareholders require a 15% return to hold the common stock, what is each share worth in the market?
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© 2004 by Nelson, a division of Thomson Canada Limited 22 Nonconstant Growth: Solution Draw a time line showing the expected cash flows. Each dividend must be calculated, using the growth rate for the period. 04321 ∞ $1.00 $1.20 $1.44 $1.73$1.90 20% 10%
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© 2004 by Nelson, a division of Thomson Canada Limited 23 Nonconstant Growth: Solution
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© 2004 by Nelson, a division of Thomson Canada Limited 24 Nonconstant Growth: Solution
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© 2004 by Nelson, a division of Thomson Canada Limited 25 Nonconstant Growth: Helpful Hints Draw a timeline Calculate each dividend on the timeline During the period of nonconstant growth, present value dividends back to time zero Once growth has stabilized: Calculate the present value of all dividends from that point forward out to infinity. Calculated value must be brought back to time zero. Example: Dividend 4, multiply by:
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© 2004 by Nelson, a division of Thomson Canada Limited 26 Sources of Growth Rate Forecasts Value Line Investment Survey www.valueline.com Thompson Financial/First Call www.tfn.com Zacks Earnings Estimates www.zacks.com
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© 2004 by Nelson, a division of Thomson Canada Limited 27 Major Points Common shares are a form of long-term financing for a firm. The value of a common share is equal to the present value of its future cash flows. The value of a common share is determined using: Zero growth model (preferred shares) Constant growth model (blue chip stocks) Nonconstant growth model (growth stocks)
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