1. 8 - 1 Principles of Business Finance Fin 510 Dr. Lawrence P. Shao Marshall University Spring 2002

2. 8 - 2 CHAPTER 8 Stocks and Their Valuation Features of common stock Determining common stock values Efficient markets Preferred stock

3. 8 - 3 Represents ownership. Ownership implies control. Stockholders elect directors. Directors elect management. Management’s goal: Maximize stock price. Facts about Common Stock

4. 8 - 4 Social/Ethical Question Should management be equally concerned about employees, customers, suppliers, “the public,” or just the stockholders? In enterprise economy, work for stockholders subject to constraints (environmental, fair hiring, etc.) and competition.

5. 8 - 5 Classified stock has special provisions. Could classify existing stock as founders’ shares, with voting rights but dividend restrictions. New shares might be called “Class A” shares, with voting restrictions but full dividend rights. What’s classified stock? How might classified stock be used?

6. 8 - 6 When is a stock sale an initial public offering (IPO)? A firm “goes public” through an IPO when the stock is first offered to the public.

7. 8 - 7 One whose dividends are expected to grow forever at a constant rate, g. Stock Value = PV of Dividends What is a constant growth stock?

8. 8 - 8 For a constant growth stock, If g is constant, then:

9. 8 - 9 $ 0.25 Years (t) 0

10. 8 - 10 What happens if g > k s ? If k s < g, get negative stock price, which is nonsense. We can’t use model unless (1) k s > g and (2) g is expected to be constant forever.

11. 8 - 11 Assume beta = 1.2, k RF = 6%, and k M = 11%. What is the required rate of return on the firm’s stock? k s = k RF + (k M - k RF )b Firm = 6% + (11% - 6%) (1.2) = 12%. Use the SML to calculate k s :

12. 8 - 12 D 0 was $0.25 and g is a constant 6%. Find the expected dividends for the next 3 years, and their PVs. k s = 12%. 01 0.2809 2 0.2978 3 g=6% 4 0.2366 0.2239 0.2120 D 0 =0.25 12% 0.265

13. 8 - 13 What’s the stock’s market value? D 0 = 0.25, k s = 12%, g = 6%. Constant growth model:

14. 8 - 14 What is the stock’s market value one year from now, P 1 ? D 1 will have been paid, so expected dividends are D 2, D 3, D 4 and so on. Thus, Could also find P 1 as follows: ^ ^ ^

15. 8 - 15 Find the expected dividend yield, capital gains yield, and total return during the first year.

16. 8 - 16 Rearrange model to rate of return form: Then, k s = $0.265/$4.42 + 0.06 = 0.06 + 0.06 = 12%. ^

17. 8 - 17 What would P 0 be if g = 0? The dividend stream would be a perpetuity. 0.25 0123 12%... ^

18. 8 - 18 Can no longer use constant growth model. However, growth becomes constant after 3 years. ^ If we have supernormal growth of 30% for 3 years, then a long-run constant g = 10%, what is P 0 ? k is still 12%.

19. 8 - 19 Nonconstant growth followed by constant growth: 0 0.2902 0.3368 0.3910 21.5029 1234 k s =12% 22.52 = P 0 g = 30% g = 10% D 0 = 0.250.32500.4225 0.5493 0.6042 ... $30.P 3 06042 12010 21    0... ^

20. 8 - 20 If g = -6%, would anyone buy the stock? If so, at what price? Firm still has earnings and still pays dividends, so P 0 > 0:

21. 8 - 21 What is market equilibrium? In equilibrium, stock prices are stable. There is no general tendency for people to buy versus to sell. In equilibrium, expected returns must equal required returns: k s = D 1 /P 0 + g = k s = k RF + (k M - k RF )b. ^

22. 8 - 22 How is equilibrium established? If k s = + g > k s, then P 0 is “too low” (a bargain). Buy orders > sell orders; P 0 bid up; D 1 /P 0 falls until D 1 /P 0 + g = k s = k s. ^ ^ D1P0D1P0

23. 8 - 23 Why do stock prices change? 1. k i could change: k i = k RF + (k M - k RF )b i k RF = k* + IP 2. g could change due to economic or firm situation.

24. 8 - 24 What’s the Efficient Market Hypothesis? EMH: Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or better information.

25. 8 - 25 1.Weak-form EMH: Can’t profit by looking at past trends. A recent decline is no reason to think stocks will go up (or down) in the future. Evidence supports weak-form EMH, but “technical analysis” is still used.

26. 8 - 26 2.Semistrong-form EMH: All publicly available information is reflected in stock prices, so doesn’t pay to pore over annual reports looking for undervalued stocks. Largely true, but superior analysts can still profit by finding and using new information.

27. 8 - 27 3.Strong-form EMH: All information, even inside information, is embedded in stock prices. Not true--insiders can gain by trading on the basis of insider information, but that’s illegal.

28. 8 - 28 Markets are generally efficient because: 1.15,000 or so trained analysts; MBAs, CFAs, Technical PhDs. 2.Work for firms like Merrill, Morgan, Prudential, which have much money. 3.Have similar access to data. 4.Thus, news is reflected in P 0 almost instantaneously.

29. 8 - 29 Preferred Stock Hybrid security. Similar to bonds in that preferred stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock. However, unlike interest payments on bonds, companies can omit dividend payments on preferred stock without fear of pushing the firm into bankruptcy.

30. 8 - 30 What’s the expected return of preferred stock with V p = $50 and annual dividend = $5?