Chapter7

# Chapter7 - FIN3100 Chapter 7 Stock Valuation Learning...

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FIN3100: Chapter 7 Stock Valuation

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Learning Objectives See how to value common stock Consider features of common and preferred stocks Review the structure of stock markets Understand the concept of an efficient market
Cash Flows to Stockholders If you buy a share of stock, you can receive cash in two ways. The company pays dividends. You sell your shares to another investor in the market or back to the company. As with bonds, the price of the stock is the present value of these expected cash flows.

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One-Period Example Suppose you are thinking of purchasing the stock of MMC, Inc. and you expect it to pay a \$2 dividend in one year. 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. Price = (14 + 2) / (1 + .2) = \$13.33
Two-Periods 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

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Keep Pushing Back the Sale Date 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?
Three Models Constant dividend 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. Non-constant growth Dividend growth is not consistent initially, but settles down to constant growth eventually. NOTE: What if horizon is finite?

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Constant Dividend Model If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity. • PV = PMT/r
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Chapter7 - FIN3100 Chapter 7 Stock Valuation Learning...

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