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best interest.
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Security Valuation
y 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.
y Equity
y Ownership interest y Common stockholders vote for
rights y Interest is considered a cost of doing business and is tax deductible y Creditors have legal recourse if interest or principal payments are missed y Excess debt can lead to financial distress and bankruptcy
the board of directors and other issues y Dividends are not considered a cost of doing business and are not tax deductible y Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid y An all equity firm can not go bankrupt
ways
y The company pays dividends y You sell your shares, either to another investor in the
Preferred Stock
A hybrid security
y Its like common stock - no fixed maturity.
y Technically, its part of equity capital.
constitute default.
stock.
y Cumulative feature: all past unpaid preferred stock
dividends must be paid before any common stock dividends are declared.
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to interest rates.
y Participation: some (very few) preferred stocks have
many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares.
Vps =
D kps
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Example
y If we know XYZs preferred stock is selling at
RM40, and the preferred dividend is RM4.125, the expected return is:
kps
D = Po
4.125 = = .1031 40
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Vps =
RM43.42
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Common Stock
y Is a variable-income security.
y Dividends may be increased or decreased,
depending on earnings. y Represents equity or ownership. y Includes voting rights. y Limited liability: liability is limited to amount of owners investment. y Priority of claim: lower than debt and preferred.
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directors.
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ONE year. XYZ is expected to pay a RM2.50 dividend at the end of the year. The stock price is expected to be RM15 at that time. y If you require a 15% rate of return, how much would you pay for the stock now?
? 0
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addition to the dividend in one year, you expect a dividend of RM3 in two years and a stock price of RM16 at the end of year 2. Now how much would you be willing to pay?
+ RM2.27 + RM12.10
addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of RM4.00 at the end of year 3 and the stock price is expected to be RM17.50 in year 3. Now how much would you be willing to pay today?
VCS = RM2.50/(1.15) + RM3/(1.15)2 + (RM4 + RM17.50) / (1.15)3 = RM2.17 + RM2.27 + RM14.14 = RM18.58
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payments?
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Constant Dividend
(Zero Growth)
y Assume that dividends will remain at the same level
forever
Div 1 Div 2 Div 3 VCS ! . 1 2 3 (1 kcs ) (1 kcs ) (1 kcs) Div VCS ! kcs
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Zero Growth
y If dividends are expected at regular intervals forever, then this is a perpetuity and the present value of expected future dividends can be found using the perpetuity formula
y
P0 = D / kcs
y Suppose stock is expected to pay a RM0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price?
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Constant Growth
(Dividend Growth Model)
Assume that dividends will grow at a constant rate, g, forever, i.e.,
Div 1 ! Div 0 (1 g )
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Constant Growth
(Dividend Growth Model)
Assumes common stock dividends will grow at a constant rate into the future.
D1 Vcs ! kcs g
D0 (1 g ) Vcs ! kcs g
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Constant Growth
(Dividend Growth Model)
y Assumes common stock dividends will grow at a
y D1 = the dividend at the end of period 1. y kcs = the required return on the common stock. y g = the constant, annual dividend growth rate.
y provided kcs > g
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Constant Growth
(Dividend Growth Model)
Example 1:
y XYZ stock recently paid a RM5.00 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%?
Vcs =
D0(1+g) kcs - g
5(1.10)
.15 - .10
RM110
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Constant Growth
(Dividend Growth Model)
Example 2: y Suppose ABC is expected to pay a RM2 dividend in one year. If the dividend is expected to grow at 5% per year and the market required return is 20%, what is the price?
0.15
0.2
D1 = RM2; g = 5%
200 Stock Price 150 100 50 0 0 0.05 0.1 0.15 Growth Rate
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0.2
0.25
0.3
Nonconstant Growth
(Supernormal growth)
Example:
y Suppose a firm is expected to increase dividends by 20%
in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was RM1 and the required return is 20%, what is the price of the stock?
y Remember that we have to find the PV of all expected
future dividends!!!
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D Vcs = kcs - g
k =
D1 Po
+ g
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Example 1:
y If you purchase a stock that will pay a RM3.00 dividend at
time 1, at a price of RM27 and an expected growth rate of 5%. How much is your expected return on this stock?
kcs =
kcs
D1 Po
) + g
=(
3.00 27
+ .05 = 16.11%
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Example 2:
y If you purchase a stock that paid a RM3.00 dividend
recently, at a price of RM27 and an expected growth rate of 5%. How much is your expected return on this stock?
kcs =
kcs = ( 27
D1 Po
) + g
+ .05 = 16.67%
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3.00 (1.05)
Example 3:
y If you purchase a stock that will pay a fixed dividend of
RM3.00 (i.e. growth =0), at a price of RM27. How much is your expected return on this stock?
kcs =
kcs = 3.00 27
D1 Po
= 11.11%
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