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Preferred share is share that has a claim against income and assets before ordinary
share but after debt. Often, preferred share considered a hybrid security because it
possesses characteristics of both debt and equity. Generally, preferred share is
considered similar to ordinary (common) equity share because they do not have
maturity and similar to debt in that both securities have fixed payments, dividends for
preferred share and interest for debt.
Preferred share valuation is relatively simple if the firm pays fixed dividends at the end
of each year. If this condition holds, then the stream of dividend payments can be
treated in perpetuity and be discounted by the investors required rate of return on a
preferred share has high risk, investors normally require a higher rate of return. This is
because creditors have priority over preferred shareholders in their claims to both
income and investors.
Thus, the intrinsic value of a share of preferred share (Po) is the sum of the present
value of future dividends discounted at the investors required rate of return. This also
can be determined using the following valuation model.
Po= Dp
Kp
Where: Dp= Per share cash dividend
Kp= Investors required rate of return on preferred share
For example, Federal Electric Company has an issue of preferred share outstanding
that pays a yearly dividend of P 10.80. Investors require a 12 % return on this preferred
share.
Determine the intrinsic value of the preferred share.
Solution:
Po = P 10.80
12 %
P90.00
Po=
Where: Dt= Per share cash dividend paid on ordinary equity in period t
Pn= Per share price of ordinary equity in period n
Kr= Investors required rate of return on ordinary equity share
P 50
P 55.20
1 + 0.15
P 48.00
1.15
This indicate that the investor should pay no more than P 48 per share for a share of
Holy Lnads share to realize an expected return of 15 %.
This model assumes that an investor plans to purchase an ordinary share and hold it
indefinitely. Hence, the returns are only I the form of dividends over multiple periods.
The following equation is an infinite period model that shows the intrinsic value of a
share of ordinary share is equal to the expected stream of dividends discounted at the
investors required rate of return.
The above equation can be simplified into the following valuation model:
Pn=
Dp
Ks
Illustrative Case: Calculations of the Intrinsic Value of Ordinary Equity Share Under the
Infinite- period Dividend Valuation
Using the data, determine the intrinsic value of oordinary equity share under the infinite
period dividend valuation
Answer: P = D p
Ks
P = P 5.20
15 %
= P 34.67
The valuation models to determine the value of ordinary equity shares based on
dividends growth rates include the following:
A. Zero Growth Dividend Model
B. Constant Growth Dividend Model
C. Supernatural Growth Dividend Model
= P 3.00
= P 20.00
1.15
Pn=
D1
ks - g
Pn
P 2.10
1.15 - 0.05
P 21.00
Illustrative Case: Calculations of Share Value Using the Supernatural Growth Dividend
Model
QC Company expects dividends to grow at a rate of 10 percent a year for the next five
years and 6 percent a year there after. The firms current dividend is P 2.00 per share.
An investor who requires a 16 percent rate of return would compute the value of QCs
ordinary shares in four steps.
Step 1 :
Find the present value of the dividends during the above normal growth model.
Year
1
2
3
4
5
Dividend
P2.00 (1.100) - P2.20
P2.00 (1.210)-2.42
2.00 (1.331)- 2.66
2.00 (1.464)- 2.93
2.00 (1.611)-3.22
Present Value of
Intrinsic Factor
0.862
0.763
0.641
0.552
0.476
Step 2: Find the present value of the stock price in year 5. This step involves calculating
the share value at the end of year 5.
P5= P3.22 x 0.06
10 %
= P 3.413
10 %
= P 34.13
Step 3 : Discount the share value at the end of year 5 to the present at the 16 %
required rate of return.
PV (P5) = P 34.13(0.40 %)
=
P 16.25
Step 4: Add the present value of the 5 years dividends and the present value of the
share in tear 5 to get the value of the share at the end of the above normal growth
model.
Po = P 8.56 + P 16.25
= P 24.81