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Chapter_08_10th_Ed

Chapter_08_10th_Ed - CHAPTER 8 Stock Valuation CHAPTER...

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CHAPTER 8 Stock Valuation CHAPTER ORIENTATION This chapter continues the introduction of concepts underlying asset valuation began in Chapter 7. We are specifically concerned with valuing preferred stock and common stock. We also look at the concept of a stockholder’s expected rate of return on an investment. CHAPTER OUTLINE I. Preferred Stock A. Features of preferred stock 1. Owners of preferred stock receive dividends instead of interest. 2. Most preferred stocks are perpetuities (non-maturing). 3. Multiple classes, each having different characteristics, can be issued. 4. Preferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy. 5. Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared. 6. Preferred stock may contain other protective provisions, such as granting voting rights in the event of non-payment of dividends. 7. Preferred stock may contain provisions to convert to a predetermined number of shares of common stock. 8. Some preferred stock contains provisions for an adjustable rate of return. 9. If there is a participation feature, it allows preferred stockholders to participate in earnings beyond the payment of the stated dividend. 10. Payment-in-kind (PIK) preferred stock, grants the investor additional preferred stock instead of dividends for a given period of time. Eventually cash dividends are paid. 201
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11. Retirement features for preferred stock are frequently included. a. Callable preferred refers to a feature which allows preferred stock to be called, or retired, like a bond. b. A sinking fund provision requires the firm periodically set aside an amount of money for the retirement of its preferred stock. B. Valuation of preferred stock (V ps ): The value of a preferred stock equals the present value of all future dividends. If the stock is nonmaturing, where dividends are expected in equal amount each year in perpetuity, the value may be calculated as follows: V ps = = II. Common Stock A. Features of Common Stock 1. As owners of the corporation, common shareholders have the right to the residual income and assets after bondholders and preferred stockholders have been paid. 2. Common stockholders are generally the only security holders with the right to elect the board of directors. 3. Preemptive rights (if granted) entitle the common shareholder to maintain a proportionate share of ownership in the firm. 4. Common stockholder’s liability as an owner of the corporation is limited to the amount invested in the stock. 5. Common stock’s value is equal to the present value of all future cash flows expected to be received by the stockholder. B. Valuing common stock 1. Company growth occurs by: a. the infusion of new capital, or b. the retention of earnings, which is called internal growth. The internal growth rate of a firm equals: Return on equity × 2. Although the bondholder and preferred stockholder are promised a
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