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Unformatted text preview: CHAPTER 8 Valuation and Characteristics of Stock CHAPTER ORIENTATION This chapter continues the introduction of concepts underlying asset valuation begun in Chapter 7. We are specifically concerned with valuing preferred stock and common stock. We also look at the concept of a stockholders expected rate of return on an investment. CHAPTER OUTLINE I. Preferred Stock A. Features of preferred stock 1. Owners of preferred stock receive dividends instead of interest. 2. Most preferred stocks are perpetuities (non-maturing). 3. Multiple classes, each having different characteristics, can be issued. 4. Preferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy. 5. Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared. 6. Preferred stock may contain other protective provisions. 7. Preferred stock contains provisions to convert to a predetermined number of shares of common stock. 8. Retirement features for preferred stock are frequently included. a. Callable preferred refers to a feature which allows preferred stock to be called or retired, like a bond. b. A sinking fund provision requires the firm periodically to set aside an amount of money for the retirement of its preferred stock. 252 B. Valuation of preferred stock (V ps ): The value of a preferred stock equals the present value of all future dividends. If the stock is nonmaturing, where dividends are expected in equal amount each year in perpetuity, the value may be calculated as follows: V ps = = II. Common Stock A. Features of Common Stock 1. As owners of the corporation, common shareholders have the right to the residual income and assets after bondholders and preferred stockholders have been paid. 2. Common stock shareholders are generally the only security holders with the right to elect the board of directors. 3. Preemptive rights entitle the common shareholder to maintain a proportionate share of ownership in the firm. 4. Common stock shareholders liability as owners of the corporation is limited to the amount of their investment. 5. Common stocks value is equal to the present value of all future cash flows expected to be received by the stockholder. B. Valuing common stock 1. Dividend valuation model a. Company growth occurs either by: (1) The infusion of new capital. (2) The retention of earnings, which we call internal growth. The internal growth rate of a firm equals: Return on equity X b. Although the bondholder and preferred stockholder are promised a specific amount each year, the dividend for common stock is based on the profitability of the firm and the management's decision either to pay dividends or retain profits for reinvestment....
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