Lecture 4 no sol

Lecture 4 no sol - IMSE3010 Financial Engineering Lecture 4...

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Unformatted text preview: IMSE3010 Financial Engineering Lecture 4 Common Stocks Discrete Time Market Model Miao Song Dept of Industrial & Manufacturing Systems Engineering 2/1/2011 2 2/1/2011 2 Review of Lecture 3 ¡ Fixed-Income Assets ¢ Yield-To-Maturity ¢ Forward Interest Rates ¢ Risk Associated with Bonds ¡ Common Stocks ¢ Introduction to Stock Markets 2/1/2011 3 2/1/2011 3 Agenda ¡ Common Stocks ¢ Introduction to Stock Markets ¢ Discounted Cash Flow Model ¢ Modeling Cash Flows ¢ EPS, P/E and Growth Opportunity ¡ Discrete Time Market Model Introduction To Stock Markets ¡ What is common stock? ¡ Organization of Stock Market ¢ Primary Market: VC, IPO, Secondary Offering ¢ Secondary Market: exchanges, OTC ¡ Trading in Secondary Market ¢ Trading cost ¡ Commission ¡ Bid-ask spread ¡ Price impact ¢ Buy on margin ¢ Long and short 2/1/2011 4 2/1/2011 4 2/1/2011 5 2/1/2011 5 Agenda ¡ Common Stocks ¢ Introduction to Stock Markets ¢ Discounted Cash Flow Model ¢ Modeling Cash Flows ¢ EPS, P/E and Growth Opportunity ¡ Discrete Time Market Model 2/1/2011 6 2/1/2011 6 Discounted Cash Flow Model (DCF) ¡ DCF: Stock price is the present value of future dividend ¡ Inputs ¢ D t : Expected future dividend ¢ r t : Risk-adjusted discount rate for cash flow at t ¡ Let P t denote the expected stock price at t (ex-dividend) ¡ What is P if you hold the stock forever? Additional assumption: r t = r 2/1/2011 7 2/1/2011 7 Valuation Based on Finite Holding Period ¡ What is P if you sell the stock at t = 1? ¡ What determines P 1 ? ¡ Thus, Observations ¡ DCF does not require holding the stock forever ¡ Applications of DCF involve further information on ¢ Future dividends ¢ Discount rates ¡ DCF can be applied to value a project, company or asset 2/1/2011 8 2/1/2011 8 2/1/2011 9 2/1/2011 9 Agenda ¡ Common Stocks ¢ Introduction to Stock Markets ¢ Discounted Cash Flow Model ¢ Modeling Cash Flows ¢ EPS, P/E and Growth Opportunity ¡ Discrete Time Market Model 2/1/2011 10 2/1/2011 10 DCF with Constant Growth ¡ Suppose that dividends are expected to grow at a constant rate g in perpetuity D t+1 = (1 + g) × D t ¡ What is P ? ¡ Gordon Model 2/1/2011 11 2/1/2011 11 Example ¡ Dividends are expected to grow at 6% per year and the current dividend is $1 per share. The expected rate of return is 20%. What should be the current stock price? 2/1/2011 12 2/1/2011 12 DCF with Constant Growth (cont.) ¡ A relation between current stock price, current dividend, dividend growth rate and the expected return ¡ Knowing three of the variables, we can determine the fourth 2/1/2011 13 2/1/2011 13 Example ¡ Determine cost of equity (the discount rate). In 09/92, the Determine cost of equity (the discount rate)....
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This note was uploaded on 12/09/2011 for the course IMSE 0301 taught by Professor Song during the Spring '11 term at HKU.

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Lecture 4 no sol - IMSE3010 Financial Engineering Lecture 4...

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