lecture 24 - Business Finance Lecture 24 Review of the...

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126 Business Finance Lecture 24 Review of the Previous Lecture Some Special Cases in Stock Valuation Zero growth Stocks Constant Growth Stocks Non-Constant Growth Stocks Topics under Discussion Non-constant Growth Stocks (cont.) Components of Required Return Common Stock Features Preferred Stock Features Non-Constant Growth Stocks CR Inc.: A Case of Supernormal Growth The company has been growing at a phenomenal rate of 30% per year. You expect that this growth rate to last for 3 more years and the rate will then drop to 10% per year. Total dividends just paid were $5 million, and required return is 20% If the growth rate then remains at 10% indefinitely, what is the total value of the stock? It is unlikely that a 30% supernormal growth rate can be sustained for any extended length of time. To value the equity in this company, we first need to calculate the total dividend over the supernormal growth period: Year Total Dividend (in millions) 1 $5.00 x 1.3 = $ 6.500 2 $6.50 x 1.3 = 8.450 3 $8.45 x 1.3 = 10.985 The price at time 3 can be calculated as: P 3 = D 3 x (1 + g) /(R - g) where g is the long-run growth rate. So we have: P 3 = $10.985x1.10/(0.20 – 0.10) = $120.835 Non-Constant Growth Stocks To determine the value today, we need the present value of this amount plus the present value of the total dividends: P 0 = D 1 D 2 D 3 _ P 3 _ (1 + R) 1 (1 + R) 2 (1 + R) 3 (1 + R) 3 $6.50 8.45 10.985 120.835_ 1.10 1 1.10 2 1.10 3 1.10 3 = $5.42 + 5.87 + 6.36 + 69.93 = $87.58 (mill.)
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127 The per share value will be $87.58 / 20 = $4.38 per share Components of Required Return Let’s examine the implications of the dividend growth model for the required return of Discount rate R. We calculated P0 as P 0 = D 1 / (R - g) Rearranging it to solve for R, we get R – g = D 1 /P 0 R = D 1 /P 0 + g This tells us that the total return, R, has two components D 1 /P 0 is called the Dividend Yield . Because this is calculated as the expected cash dividend by the current price, it is conceptually similar to the current yield on a bond Growth rate, g, is also the rate at which the stock price grows. So it can be interpreted as capital gains yield Suppose a stock is selling for $20 per share. The next dividend is $1 per share and it is expected to grow by 10% more or less indefinitely. What return does this stock offer you if this is correct? The dividend growth model calculates the total return as R = D 1 /P 0 + g = $1/20 + 10% = 5% + 10% = 15% We can verify this answer by calculating the price in one year, P1, using 15% as the required return. Based on the dividend growth model, the price is:
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lecture 24 - Business Finance Lecture 24 Review of the...

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