chapter 9 note

# chapter 9 note - Chapter 9 Common Stock Valuation By Dr M...

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1 Chapter 9 Common Stock Valuation By Dr. M. Metghalchi Common stock Common stockholders bear the residual risk of a corporation’s cash flows. Common stockholders have the right to the residual income and assets after bondholders and preferred stockholders have been paid. Common stockholders elect the firm’s board of directors Firms may have different classes of stock with different voting rights Shareholders have limited liability if the firm elects to default on its debt. The liability is limited to the amount of their investment in the firm. Dividend payments to shareholders are not tax deductible. Shareholders have the right to share in stock offerings: preemptive right entitles the common shareholder to maintain a proportionate share of ownership in the firm. Generally, the bondholder and preferred stockholder are promised a fixed amount each year, the dividend for common stock is based on the profitability of the firm and the management's decision either to pay dividends or retain profits for reinvestment. Common stock’s intrinsic (theoretical) value is equal to the present value of all future cash flows expected to be received by the stockholder. P 0 = V cs = 1 cs 1 ) k (1 D + + 2 cs 2 ) k (1 D + +...+ + ) k (1 D cs (1) Where , D1, D2, D are Dividends in year 1, 2 and infinity. K cs = Cosk of common stock (or common equity) or required rate of return on the common stock for simplicity, sometimes we use the notation K s = cost of stock or required rate of return on the stock, your textbook uses k for. So, for the rest of this lecture, I use K s = cost of common stock or cost of equity or required rate of return on the stock. V cs = The intrinsic or theoretical value of the common stock (PV of all future cash flows expected to be received by the stockholder if the buy the stock). P 0 = Market price of the stock. (note, in equation 1, I am assuming that the market is in

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2 equilibrium and the market price is equal to intrinsic value, this is the position of efficient market hypothesis). Since equation 1 is difficult to work with, we make some assumptions that makes easy to work with the equation 1. We consider 3 different assumptions: Earnings and dividend are not growing ( zero growth model ) Earnings and dividends are growing at a constant rate, g, for the foreseeable future. ( constant growth model ) Earnings and dividends are growing at different rate at various stages ( multi- stage growth model) Zero Growth Model: If we assume that earnings and dividends are not growing at all, then: D1=D2=D3= …… D 4 in equation (1) and equation 1 becomes the estimation of the present value of a constant amount forever, this is a perpetuity, and we get: P 0 = V cs = D/ K s (equation 9-2 on page 306) (2) Example: Assume Victoria Inc.‘s last year dividend was \$2.0 and this dividend is expected to remain constant for the foreseeable future. If the required rate of return on VI is 10%, what is the value of VI’s stock?
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