MGNT3125_chapter9_notes

MGNT3125_chapter9_notes - MGNT3125 Fall 2010 Dr. Amine...

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MGNT3125 Fall 2010 Dr. Amine Khayati Chapter 9 Notes I- Common Stock valuation: There are three factors complicating the valuation of common stocks. First, dividend payments are not fixed over time and can change substantially from one year to another. Second, a share of a common stock has neither a maturity date nor a maturity value, unlike a bond which has a maturity date and a future value. Third, quite similar to the bond valuation, it is difficult to estimate the appropriate required rate of return for a stock. Cash flows: Investors purchase common stock expecting returns in the form of dividends and/or future price appreciation. So, an investor who plans to hold a stock for t years would value the stock using the current price as present value, the expected dividends payments to be received over the period of t years, the expected future selling price as future value and the required rate of return on that stock as the discounting interest rate. Example 1: You decide to buy a stock today. You plan to sell the stock a year from today, and you estimate that the stock will be worth $70 at that time. You also predict that the stock will pay $5 per share dividend at the end of the year. If you require a 15% on that stock, what would you pay for that stock today? = =……………………………………………………………. = stock price today = stock price at year 1 = expected dividend in year 1 R = required rate of return Example 2: same as example 1 except in this case you decide to hold the stock for three years. You predict that the dividend at the end of year 1 to be $5, at the end of year 2 to be $7 and at the end of year 3 to be $9. You also predict that you can sell the stock at the end of year 3 for $70. What would you pay for that stock today? = + + + =……………………………………………… 1
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Some special cases: Because of the difficulty of estimating the future dividends, we make three simplifying assumptions regarding the pattern of future dividends payments. They are: (1) zero growth in dividends, or constant dividends; (2) constant rate of growth in dividends; and, (3) a non-constant rate of growth in dividends. 2
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Zero Growth or constant dividend: A stock with constant dividends is a perpetuity. The stock is assumed to pay the same amount of dividend for ever. So its current price could be approximated by: = = stock price today D = the constant dividend R = the required rate of return on the stock Constant Growth dividend: Suppose that the dividend for some company always grows at a steady rate. Call this growth rate g . if we let be the dividend just paid, the next dividend,
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MGNT3125_chapter9_notes - MGNT3125 Fall 2010 Dr. Amine...

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