BCOR 2200 Chapter 7

BCOR 2200 Chapter 7 - Chapter 7 Equity Markets Stock...

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1 Chapter 7 Equity Markets & Stock Valuation

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2 Outline: Common Stock Valuation Features of Common and Preferred Stocks The Stock Markets Concepts and Skills: Understand how stock prices depend on future dividends and dividend growth Be able to compute stock prices using the dividend growth model Understand how corporate directors are elected Understand how stock markets work Understand how stock prices are quoted
3 7.1 Common Stock Valuation Share of Ownership Entitles you to: 1. Share of Profits 2. Share of Assets If the company is liquidated After creditors (including bond holders) get their money 3. Share of vote for Board of Directors A Share is worth the PV all future cash flows: 1. Profits paid to share holders – Cash Dividends 2. Cash received from the sale of the stock Sold to another investor Sold back to the company

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4 Example: Hold for 1 year A share of stock will pay a \$2 dividend in one year It will be worth \$14 in one year You require a 20% return on investments with this risk Calculate the most you are willing to pay P 0 = Price at time 0 D 1 = Dividend at time 1 P 1 = Price at time 1 ( 29 ( 29 33 . 13 \$ 0 2 . 1 14 \$ 2 \$ R 1 P D P 1 1 1 1 0 = + = + + =
5 Example: Hold for 2 years Div at time 2 = \$2.10 D 1 = \$2 and D 2 = \$2.10 Price at time 2 = P 2 = \$14.70 Still require a 20% return Cash flow diagram: ( 29 ( 29 ( 29 ( 29 33 . 13 \$ 0 2 . 1 70 . 14 \$ 10 . 2 \$ 0 2 . 1 2 \$ R 1 P D R 1 D P 2 1 2 2 2 1 1 0 = + + = + + + + = P 0 \$14.70 0 1 2 \$2.00 \$2.10

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Clicker Question: 6

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8 General Formula Derivation (Part 1): P 0 is a function of D 1 and P 1 But P 1 is a function of D 2 and P 2 . So Sub for P 1 in P 0 equation: ( 29 R 1 P D P 2 2 1 + + = ( 29 R 1 P D P 1 1 0 + + = ( 29 ( 29 ( 29 ( 29 2 2 2 1 1 0 2 2 1 0 R 1 P D R 1 D P R 1 R 1 P D D P + + + + = Þ + + + + =
9 General Formula Derivation (Part 2): So now P 0 is a function of D 1 , D 2 and P 2 But P 2 can be written as a function of D 3 and P 3 So Sub for P 2 in P 0 equation and get P 0 as a function D 1 , D 2 , D 3 and P 3 : But P 3 can be written as a function of D 4 and P 4 and so on… ( 29 R 1 P D P 3 3 2 + + = ( 29 ( 29 2 2 2 1 1 0 R 1 P D R 1 D P + + + + = ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 3 3 3 2 2 1 0 2 3 3 2 1 0 R 1 P D R 1 D R 1 D P R 1 R 1 P D D R 1 D P + + + + + + = Þ + + + + + + = ( 29 ( 29 ( 29 ( 29 L + + + + + + + + = 4 4 3 3 2 2 1 0 R 1 D R 1 D R 1 D R 1 D P

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10 General Formula Discussion The price at any time (including now) is the present value of all future cash flows (dividends) Its as if we are just pushing back the sale time to include the next dividend. So how can we estimate all future dividend payments? First we’ll make some simple assumptions and look at those cases: Assumption 1: Dividends are the same forever: D 0 = D 1 = D 2 = … Assumption 2: Dividends grow at a constant rate: D 1 = D 0 (1 + g) Assumption 3: Dividends grow fast now, but at a constant rate later ( 29 ( 29 ( 29 ( 29 L + + + + + + + + = 4 4 3 3 2 2 1 0 R 1 D R 1 D R 1 D R 1 D P
11 Dividends are Constant Forever: D 0 = D 1 = D 2 = D 3 = D (with no subscript) This is just the Present Value of a Perpetuity.

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