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121
Business Finance
Lecture 23
Review of the Previous Lecture
•
Bond Valuation
–
Determinants of Term Structure
•
Real Rate of Interest
•
Expected inflation
•
Interest Rate Risk
–
Bond Yields and the Yield Curve
•
Equity Markets and Stock Valuation
–
Common Stock Valuation
Topics under Discussion
•
Some Special Cases in Stock Valuation
–
Zero growth Stocks
–
Constant Growth Stocks
–
NonConstant Growth Stocks
Zero Growth Stocks
•
A share of common stock in a company with a constant dividend is termed as zero growth type
of stocks. Which implies:
D
1
= D
2
= D
3
= D = constant
•
So the value of the stock is:
P
0
=
D
D
D
_
D
_
…
(1 + R)
1
(1 + R)
2
(1 + R)
3
(1 + R)
4
•
Since dividend is always the same, the stock can be viewed as an ordinary perpetuity with a
cash flow equal to D every period.
•
So the per share value is
P
0
= D/R
where R is the required rate of return
•
CVP corporation has a policy of paying a $10 per share dividend every year.
•
If this policy is to continue indefinitely, what is the value of a share of stock if the required
rate of return is 20%?
•
Since the stock amounts to be a perpetuity, value of the share is
$10/0.20 = $50 per share
Constant Growth Stocks
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•
Stocks, the dividend for which grow at a steady rate termed as growth rate g.
•
If we let D
0
be the dividend just paid, then the next dividend, D
1
is
D
1
= D
0
x (1 + g)
•
Dividend in two periods is :
D
2
= D
1
x (1 + g)
= [D
0
x (1 + g)] x (1 + g)
= D
0
x (1 + g)
2
•
We can repeat this process to generalize it for any number of periods as
D
t
= D
0
x (1 + g)
t
•
An asset with cash flows that grow at a constant rate forever is called a growing perpetuity
•
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 Spring '11
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