Finance_final_notes

# Finance_final_notes - Chapter 8 Stock Valuation(8 1 Common...

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Chapter 8: Stock Valuation (8. 1) Common Stock Valuation - share of common stock more difficult to value than bond in practice o not even the promised cash flows are known in advance o the life of the investment is essentially forever because common stock has no maturity o there is no way to easily observe the rate of return that the market requires Common Stock Cash Flows - P 0 = (D 1 + P 1 )/(1 + r) have to know the price in one year for this o P 0 is the current price of the stock o P 1 is the price in one period o D 1 is the cash dividend paid at the end of the period o r is the required rate of return - importantly, no matter what the stock price is, the present value is essentially zero if we push it far enough away - the current price of the stock can be written as the present value of the dividends beginning in one period and extending out forever - the price of the stock today is equal to the present value of all the future dividends - P 0 = (D 1 )/(1 + r) 1 + (D 2 )/(1 + r) 2 + (D 3 )/(1 + r) 3 etc. . - When we speak of companies that don’t pay dividends, what we really mean is that they are not currently paying dividends Common Stock Valuation: Some Special Cases - some special circumstances where we can come up with a value for the stock - some simplifying assumptions: o the dividend has a zero growth o the dividend grows at a constant rate o the dividend grows at a constant rate after some length of time - 1. Zero growth o constant dividend, much like a share of preferred stock o D 1 = D 2 = D 3 = D = constant o Since the dividend is always the same, the stock can be viewed as an ordinary perpetuity with a cash flow equal to D every period P 0 = D/r - 2. Constant growth o Dividend grows at a steady rate o D 0 is the dividend just paid o D 1 is the next dividend D t = D 0 x (1 + g) t - as long as the growth rate, g, is less than the discount rate, r, the present value of this series of cash flows can be written very simply using the growing perpetuity formula

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o P 0 = ((D 0 x (1 + g))/(r - g) = D 1 /(r - g) dividend growth model - can use the dividend growth model to get the stock price at any point in time o P t = ((D t x (1 + g))/(r - g) = D t + 1 /(r - g) o Ex interested in the price of the stock in five years First need the dividend at time 5: D 5 = \$2.30 x (1.05) 5 = \$2.935 Then from the dividend growth model, the price of stock in five years is: P5 = (\$2.935 x (1.05))/(0.13-0.05) = \$38.53 - if given D1 and need to find value of the stock today do not multiply by (1+g) - and to get any future value, ie in four years it is D 1 x (1+g) 3 not 4 - the dividend growth model has the implicit assumption that the stock price will grow at the same constant rate as the dividend - if the cash flows on an investment grow at a constant rate through time, so does the value of that investment - if the constant growth rate exceeds the discount rate, the stock price is infinitely large - the present value of the dividends keeps on getting bigger and bigger, same is true if the growth
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Finance_final_notes - Chapter 8 Stock Valuation(8 1 Common...

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