ch08 - Stock Valuation Stock CH 8 Preferred Stock Preferred...

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Unformatted text preview: Stock Valuation Stock CH 8 Preferred Stock Preferred A hybrid security: It’s like common stock ­ no fixed maturity. Technically, it’s part of equity capital. It’s like debt ­ preferred dividends are fixed. Missing a preferred dividend does not constitute default, but preferred dividends are cumulative. Preferred Stock Usually sold for $25, $50, or $100 per share. Dividends are fixed either as a dollar amount or as a percentage of par value. Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. $4.125 is the fixed, annual dividend per share. Preferred Stock Features Firms may have multiple classes of preferreds, each with different features. Priority: lower than debt, higher than common stock. Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared. Preferred Stock Features Protective provisions are common. Convertibility: many preferreds are convertible into common shares. Adjustable rate preferreds have dividends tied to interest rates. Participation: some (very few) preferreds have dividends tied to the firm’s earnings. Preferred Stock Features PIK Preferred: Pay­in­kind preferred stocks pay additional preferred shares to investors rather than cash dividends. Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares. Common Stock Common Is a variable­income security. Dividends may be increased or decreased, depending on earnings. Represents equity or ownership. Includes voting rights. Limited liability: liability is limited to amount of owners’ investment. Priority: lower than debt and preferred. Common Stock Characteristics Common Claim on Income ­ a stockholder has a claim on the firm’s residual income. Claim on Assets ­ a stockholder has a residual claim on the firm’s assets in case of liquidation. Preemptive Rights ­ stockholders may share proportionally in any new stock issues. Voting Rights ­ right to vote for the firm’s board of directors. Security Valuation Security In general, the intrinsic value of an asset = the present value of the stream of expected cash flows discounted at an appropriate required rate of return. Preferred Stock Valuation Valuation A preferred stock can usually be valued like a perpetuity: Vps = D k ps Example: Xerox preferred pays an 8.25% dividend on a $50 par value. Suppose our required rate of return on Xerox preferred is 9.5%. Vps = 4.125 .095 .095 = $43.42 Expected Rate of Return on Preferred Return Just adjust the valuation formula: Vps = D k ps kps = D Po Example Example If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: kps = D Po = 4.125 = .1031 40 Common Stock Valuation (Single Holding Period) You expect XYZ stock to pay a $5.50 dividend at the end of the year. The stock price is expected to be $120 at that time. If you require a 15% rate of return, what would you pay for the stock now? ? 0 5.50 + 120 1 Common Stock Valuation Common (Single Holding Period) Solution: Vcs = (5.50/1.15) + (120/1.15) = 4.783 + 104.348 = $109.13 Common Stock Valuation Common (Multiple Holding Periods) Constant Growth Model Assumes common stock dividends will grow at a constant rate into the future. Vcs = D1 kcs - g Constant Growth Model Constant Growth Model Assumes common stock dividends will grow at a constant rate into the future. Vcs = D1 kcs - g D1 = the dividend at the end of period 1. kcs = the required return on the c/s. g = the constant, annual dividend growth rate. Example Example XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? D0 = $5, so D1 = 5 (1.10) = $5.50 Example Example XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What would we be willing to pay if our required return on XYZ stock is 15%? Vcs = D1 kcs - g = 5.50 .15 - .10 = $110 Expected Return on Common Stock Common Just adjust the valuation model Vcs = D kcs - g k= k= ( D1 Po )+g ( D1 Vcs )+g Example Example We know a stock will pay a $3.00 dividend at time 1, has a price of $27 and an expected growth rate of 5%. kcs = ( kcs = ( D1 Po )+g 3.00 27 ) + .05 = 16.11% ...
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