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Unformatted text preview: Chapter 7 Stocks and Their Valuation MINI CASE Sam Strother and Shawna Tibbs are senior vice presidents of the Mutual of Seattle. They are co-directors of the company’s pension fund management division, with Strother having responsibility for fixed income securities (primarily bonds) and Tibbs being responsible for equity investments. A major new client, the Northwestern Municipal League, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them. To illustrate the common stock valuation process, Strother and Tibbs have asked you to analyze the Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporarily heavy workloads. You are to answer the following questions. a. Describe briefly the legal rights and privileges of common stockholders. Answer: The common stockholders are the owners of a corporation, and as such, they have certain rights and privileges as described below. 1. Ownership implies control. Thus, a firm’s common stockholders have the right to elect its firm’s directors, who in turn elect the officers who manage the business. 2. Common stockholders often have the right, called the preemptive right, to purchase any additional shares sold by the firm. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it specifically into the charter. b. 1. Write out a formula that can be used to value any stock, regardless of its dividend pattern. Answer: The value of any stock is the present value of its expected dividend stream: P ˆ = . ) r 1 ( D ) r 1 ( D ) r 1 ( D ) r 1 ( D s 3 s 3 s 2 t s 1 ∞ ∞ + + + + + + + + However, some stocks have dividend growth patterns which allow them to be valued using short-cut formulas. Mini Case: 7 - 1 b. 2. What is a constant growth stock? How are constant growth stocks valued? Answer: A constant growth stock is one whose dividends are expected to grow at a constant rate forever. “Constant growth” means that the best estimate of the future growth rate is some constant number, not that we really expect growth to be the same each and every year. Many companies have dividends which are expected to grow steadily into the foreseeable future, and such companies are valued as constant growth stocks. For a constant growth stock: D 1 = D (1 + g), D 2 = D 1 (1 + g) = D (1 + g) 2 , and so on. With this regular dividend pattern, the general stock valuation model can be simplified to the following very important equation: P ˆ = g r D s 1- = g r ) g 1 ( D s- + ....
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