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# chap007 with additions - Chapter 7 Equity Markets and Stock...

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1 Chapter 7 - Equity Markets and Stock Valuation Common Stock Valuation Dividend Growth Model Features of Common and Preferred Stocks The Stock Markets

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2 Cash Flows to Stockholders Value of Any Investment = PV of future cash flows If you buy a share of stock, you can receive cash in two ways The company pays dividends You sell your shares either to another investor in the market or back to the company
3 One-Period Example Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a \$2 dividend in one year and you believe that you can sell the stock for \$14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? Compute the PV of the expected cash flows Remember PV = FV / (1 + r) t Price = (14 + 2) / (1.2) = \$13.33 Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33

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4 Two-Period Example Now, what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of \$2.10 and a stock price of \$14.70 both at the end of year 2. Now how much would you be willing to pay? PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) 2 = 13.33 Or CF 0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I = 20; CPT NPV = 13.33
5 Three-Period Example Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of \$2.205 at the end of year 3 and a stock price of \$15.435. Now how much would you be willing to pay? PV = 2 / 1.2 + 2.10 / (1.2) 2 + (2.205 + 15.435) / (1.2) 3 = 13.33 Or CF 0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33

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6 Developing The Model You could continue to push back when you would sell the stock You would find that the price of the stock is really just the present value of all expected future dividends So, how can we estimate all future dividend payments?
7 Estimating Dividends: Special Cases Constant dividend – Zero Growth The firm will pay a constant dividend forever This is like preferred stock The price is computed using the perpetuity formula Constant dividend growth The firm will increase the dividend by a constant percent every period Supernormal growth – Non-Constant Dividend growth is not consistent initially, but settles down to constant growth eventually

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chap007 with additions - Chapter 7 Equity Markets and Stock...

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