Class 2 Valuation of Cash Flow Streams

Common Stock n Stockholders are owners of the firm. n Stockholders are residual claimants. n Stockholders have the right to:  vote at company meetings  dividends and other distributions  sell their shares n Stockholders benefit in two ways:  dividends  capital gains

Issuing and Trading Stock n Stock is issued by public corporations to finance investments. n Stock is initially issued in the primary market (IPOs and secondary offerings). n Stock is traded in the secondary market on organized exchanges.

World Stock Markets n New York n Tokyo n London n Frankfurt n Paris n Mexico n Canada n Brussels n Hong Kong n Singapore n Johannesburg n Sydney n Stockholm n Milan n Amsterdam n Switzerland

Major U.S. Stock Exchanges n New York Stock Exchange (NYSE) n American Stock Exchange (AMEX) n Over-The-Counter (OTC)  National Association of Securities Dealers (NASDAQ)

Major U.S. Stock Indices n Dow Jones Industrial Average n Standard & Poors 500 n NYSE Composite n NASDAQ Composite n Value Line n Russell 2000 n Wilshire 5000

Transactions Involving Stocks n Buy  Savings motive  Expect stock to appreciate in value  Long position n Sell  Liquidity needs  Expect stock to decline in value

Transactions Involving Stock n Short Sell  Sell stock without first owning it.  Borrow stock from your broker with the promise to repay it at some later date.  Sell the borrowed stock.  Repurchase it at a later date to repay your broker.  Responsible for all dividends and other distributions while short the stock.

Stock Valuation n The price an investor is willing to pay for a share of stock depends upon:  Magnitude and timing of expected future dividends.  Risk of the stock. n The stock ’ s discount rate, r e, is the rate of return investors can expect to earn on securities with similar risk.

Stock Valuation: Dividend Discount Model l The value of a stock is the present value of all future dividends:

Simplifying the Dividend Discount Model n Constant Dividends n Constant Growth

Constant Dividends: RJR Nabisco Preferred Stock n RJR Nabisco has a preferred stock outstanding with an annual dividend of $2.50 per share. If securities with similar risk are expected to return 9.6%, what is the price of the preferred stock?

Constant Growth: Duke Power Common Stock n Duke Power currently pays a dividend of $2.04 per share. With demand for electric power growing at 4% per year, and inflation averaging 3% per year, Duke Power expects its profits and dividends to grow at about 7% per year. If stockholders require a 12% rate of return, what is the market price of Duke Power ’ s common stock?

Duke Power (cont.) n Duke Power ’ s common stock price:

Valuing a Business n Consider a company with cash flows from operations of $1 million for the most recent year. n The company ’ s cash flows are expected to grow at a rate of 10% for the next 5 years and at a constant rate of 5% thereafter. n To generate this increase in cash flows, the company is required to reinvest 50% of its cash flows for the first 5 years and 25% of its cash flows thereafter. n Given the risk of the business, the required rate of return is 15%. n What is the value of the business?

Valuing a Business (cont.)

Valuing a Business n Value of dividends over the first 5 years is $2.18. n Value of business at the end of the 5th year:

Valuing a Business (cont.) n Value of the Business:

Estimating Relevant Cash Flows l The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project. Incremental = Firm ’ s CFs - Firm ’ s CFs Cash Flows with Project without Project

Estimating Relevant Cash Flows: Basic Principles l Discount Cash Flows, Not Accounting Profits. »For capital budgeting purposes, the point of recognition is when the money is actually received or spent. »Don ’ t forget the effect of taxes.

Estimating Relevant Cash Flows: Basic Principles l Separate Investment and Financing Decisions »Ignore all financing costs, even if the project is partially financed with debt. »Treat the project as if it were all-equity financed. »Financing side effects will be considered later.

Estimating Relevant Cash Flows: Basic Principles l Only Incremental Cash Flows are Relevant. »Include all incidental effects, including project interactions. »Don ’ t forget to include investment in working capital. »Forget about sunk costs. »Include all opportunity costs (e.g., land used to construct a new plant). »Beware of allocated overhead expenses.

Depreciation l Depreciation is a non-cash expense that only affects cash flows through its tax effect. l Assets are depreciated down to their estimated salvage values. l Any removal costs associated with old equipment are expensed immediately.

Depreciation l Sales tax, delivery costs, and installation are regarded as part of the cost of the new asset for depreciation purposes. l Removal costs of the old asset are not regarded as part of the cost of the new asset and are expensed immediately. l If an asset is later sold for an amount above (below) its book value, the excess is taxable (deductible).

Example: Estimating Cash Flows l A new machine costs $60,000 plus installation costs of $2,000. It generates revenues of $155,000 and expenses of $100,000 annually. It will be depreciated to its estimated salvage value over of $6,000 over its seven year life. What are the relevant cash flows?

Step 1: Compute Tax Cash Flow

Step 2: Compute Cash Flows