Intro to Financial Management Equities. Review Homework Types of bonds Bond risks Bond valuation.

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Presentation transcript:

Intro to Financial Management Equities

Review Homework Types of bonds Bond risks Bond valuation

Review Required rate of return Risk-free rate of return Market rate of return Systemic and idiosyncratic risk Beta? CAPM

Equities Financial term for stock –Can use “equities market” Represents ownership in the firm Common stock –Claim on income –Claim on assets –May pay dividends –Limited liability –Say in management Vote for board of directors Proxy –No maturity Contrast with bonds

Preferred Stock Half stock, half bond –Claim on income –Claim on assets –Defined dividend payments Failure to pay does not bring on bankruptcy Not deductible for corporate taxes –No maturity Often convertible May be retired or called

Preferred Stock Valuation A perpetuity –Like a bond that goes on forever, perpetuity Value = dividend / required rate of return = d / r

Common Stock Valuation Companies grow by reinvesting their profits Growth factor g = ROE * profit retention rate Dividend valuation model p = D1 / (r – g) Where p = value, i.e. price D1 = dividend in year 1 r = required rate of return g = growth factor Major problem – most stocks do not pay dividends

Expected Rate of Return Need something similar to bond yield to maturity Preferred stock r = dividend / price Common stock r = (dividend / price) + g r = dividend yield + g

Equity Returns Returns come from –Change in the price (capital gain / loss) –Dividends Many companies pay no dividends Most of the returns come from capital gains –The S&P 500 Index has returned an average annual return of 10% since 1926, with dividend yield accounting for only about 2% of the return. For investors, expected rate of return is what matters –Not price –Not history –Future cash flows

Investing in Equities What kind of company pays no dividends? –Why? Who would buy a dividend paying stock? –Why? Who would buy a non-dividend paying stock? –Why? Think about two stocks where one pays dividends and the other does not. –How might the stock prices compare after 10 years? Why? –Is there a winner or loser?