Chapter 07 - 7. The Stock Market, the Theory of Rational...

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7. The Stock Market, the Theory of Rational Expectations, and the Efficient Markets Hypothesis 7.1 Computing the Price of Common Stock 7.2 How the Market Sets Security Prices 7.3 The Theory of Rational Expectations 7.4 The Efficient Markets Hypothesis: Rational Ex 7.5 Evidence on the Efficient Markets Hypothesis 7.6 Evidence on Rational Expectations in Other M
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7.1 2 Common stock is the principal way that corporations raise equity capital in which shareholders have the right to vote and as residual claimant of all funds flowing into the firm. Dividend payments are made periodically One basic principle of finance is that the value of any investment is found by computing the value today of all cash flows the investment will generate over its life. Similarly, common stock is evaluated in terms of the value of today’s dollars of all future cash flows (dividends and the sales price)
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7.1 3 One-period valuation model : buy the stock and hold it for one period to get a dividend, then sell the stock. The value of the stock today is the present discounted value of the expected cash flows (future payments) using the required return on investments in equity (rather than the interest rate) as the discount factor to discount the cash flows (one dividend payment plus a final sales price) P 0 =[D 1 /(1+k e )]+[P 1 /(1+k e )]
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7.1 4 It would be a good investment if the current stock price is below P 0 . Other investors may place a different risk on the cash flows (larger discount factor) or estimate of the cash flows such that they have a different valuation result and the target price of the stock The n -period valuation model assumes the investor will receive dividends and a final sales price when the stock is ultimately sold in period n P 0 =[D 1 /(1+k e )]+[D 2 /(1+k e ) 2 ]+ … +[D n /(1+k e ) n ]+ [P n /(1+k e ) n ]
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7.1 5 Besides estimates on dividend payments in the future , the value of the stock at some point in the future must also be estimated. However, if P n is far in the future , it will not affect P 0 . This reasoning implies that the current value of a share of stock can be calculated as simply the present value of the future dividend stream. The generalized dividend model is a simplified version of the n -period valuation model with removal of the discounted future sales price P 0 =[D 1 /(1+k e )]+[D 2 /(1+k e ) 2 ]+ … +[D /(1+k e ) ]
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7.1 6 The price of stock is determined only by the present value of the dividends and that nothing else matters, but many stocks do not pay dividends . Buyers of the stock expect that the firm will pay dividends someday . Most of the time a firm institute dividends as soon as it has completed the rapid growth phase of its life cycle Calculation of the generalized dividend model can be difficult when it involves discounting an infinite stream of dividends. The Gordon growth model simplifies that by assuming a constant dividend growth rate ( g ), P 0 =D 1 /(k e -g)
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7.1 7 Assumptions (i)
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Chapter 07 - 7. The Stock Market, the Theory of Rational...

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