59533341-FM11-Ch-07-Instructors-Manual-1

In some states the preemptive right is automatically

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Unformatted text preview: m. In some states, the preemptive right is automatically included in every corporate charter; in others, it is necessary to insert it specifically into the charter. b. 1. Write out a formula that can be used to value any stock, regardless of its dividend pattern. Answer: The value of any stock is the present value of its expected dividend stream: Ö P0 = 1 (1  rs ) t  2 (1  rs )  3 (1  rs ) 3 .  g (1  rs ) g . However, some stocks have dividend growth patterns which allow them to be valued using short-cut formulas. Mini Case: 7 - 16 b. 2. What is a constant growth stock? How are constant growth stocks valued? Answer: A constant growth stock is one whose dividends are expected to grow at a constant rate forever. ³Constant growth´ means that the best estimate of the future growth rate is some constant number, not that we really expect growth to be the same each and every year. Many companies have dividends which are expected to grow steadily into the foreseeable future, and such companies are valued as constant growth stocks. For a constant growth stock: D1 = D0(1 + g), D2 = D1(1 + g) = D0(1 + g)2, and so on. With this regular dividend pattern, the general stock valuation model can be simplified to the following very important equation: Ö0 = 1 rs  g = D 0 (1  g) . rs  g This is the well-known ³Gordon,´ or ³constant-growth´ model for valuing stocks. Here D1, is the next expected dividend, which is assumed to be paid 1 year from now, rs is the required rate of return on the stock, and g is the constant growth rate. b. 3. What happens if a company has a constant g which exceeds its rs? Will many stocks have expected g > rs in the short run (i.e., for the next few years)? In the long run (i.e., forever)? Answer: The model is derived mathematically, and the derivation requires that rs > g. If g is greater than rs, the model gives a negative stock price, which is nonsensical. The model simply cannot be used unless (1) rs > g, (2) g is expected to be constant, and (3) g can reasonably be expected to continue indef...
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