1. 8 Common Stock: Characteristics, Valuation, and Issuance ©2006 Thomson/South-Western

2. 2 Introduction This chapter describes the characteristics of common stock. It discusses the process for selling securities and the role of the investment banker. The chapter also develops valuation models for common stock.

3. 3 Common Stock Common stock (C/S) is the permanent long-term financing of a firm. Represents the true residual ownership of a firm Stockholders elect the board of directors.

4. 4 Balance Sheet Accounts for C/S Par value of C/S Contributed capital in excess of par  Additional paid in capital  Capital surplus Retained earnings (R/E) Book value per share Common equity # shares outstanding =

5. 5 Rights of Common Stockholders Dividend rights Asset rights Preemptive rights Voting rights

6. 6 Voting for the Board of Directors Majority voting requires more than 50 percent of the votes to elect a director. Cumulative voting  Shareholders may concentrate votes on a few candidates. Proxy  signing over your voting rights to someone else

7. 7 Features of C/S C/S classes  Voting and nonvoting  Specific ownership Stock dividends  Transfer from R/E account to the C/S and additional paid-in capital accounts Stock repurchases  Disposition of excess cash  Financial restructuring  Future corporate needs  Reduction of takeover risk Stock splits Reverse stock splits

8. 8 C/S Advantages and Disadvantages Advantages  Flexible  Reduced financial leverage  Lower cost of capital Disadvantages  Diluted EPS  Expensive

9. 9 Investment Banking Long-range financial planning Timing of security issues Purchase of securities Marketing of securities Arrangement of private loans and leases Negotiation of mergers

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11. 11 How Are Securities Sold? Public cash offering  Selling securities through investment bankers to the public  IPO’s Web site: http://www.ipo.com/ Private or direct placement  Placing a security issue with one or more large investors Rights offering  Selling C/S to existing stockholders Standby underwriting  Investment banker purchases shares not sold to rights holder.

12. 12 Direct Issue Costs Investment bankers who agree to underwrite a security issuance assume a certain amount of risk, and receive an underwriting spread as compensation. Underwriting Spread = Selling price to public – Proceeds to company

13. 13 Other Issuance Costs Management time Underpricing new equity Stock price declines Incentives “Green shoe” option

14. 14 Registration Requirements SEC act of 1933 & SEC exchange act of 1934 Any interstate security issue over $1.5 million and having a maturity greater than 270 days is required to register issue with the SEC. Provide all buyers of the new security with a final copy of the prospectus Shelf registration Check NYSE regulations http://www.nyse.com/about/about.html

15. 15 Global Equity Markets Multinational firms can take advantage of institutional differences from one country to another. Stock markets in United States, Japan, London, and Paris Nearly 24-hour per day trading of C/S Provide investors with opportunities to buy and sell shares any time they wish Global name and product recognition

16. 16 Valuation of C/S Capitalized value of the stock’s expected stream of cash flow during holding period Uncertain Dividends Not constant Expected to grow over time Capital gain or loss

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18. 18 Dividend Valuation Models Zero growth  g = 0 Constant growth dividend  k e > g  D t = D 0 (1 + g) t Above-normal growth  Multiple growth rates

19. 19 Zero Growth

20. 20 Example of Zero Growth Valuation P 0 = $1.50 0.12 =$12.50 A share of stock will pay $1.50 dividend next year. If the required rate of return is 12%, the value of the share is:

21. 21 Constant Growth

22. 22 Example of Constant Growth Valuation P 0 = $1.76 0.12- 0.065 =$32.00 A share of stock will pay $1.76 dividend next year. The dividend will grow at a 6.5% annual rate. If the required rate of return is 12%, the value of the share is:

23. 23 Above-Normal Growth 1.Find the PV of the dividends during the above-normal growth period (if two or more above-normal growth periods continue with the PV of the second) 2a.Find the value of the C/S at the end of the above-normal growth period 2b.Discount the answer in 2a to the present time 3. Sum steps 1 and 2b to find p 0

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25. 25 Sources of Analyst Growth Rate Forecasts Value Line Investment Survey  http://www.valueline.com/ Institutional Brokers Estimate System  http://www.ibes.com/ Zacks Earnings Estimates  http://www.zacks.com/

26. 26 Valuing Small Firms Nature of business History of business Economic outlook Dividend paying capacity Industry Earnings capacity Book value Financial condition Majority or minority interest Voting or nonvoting Valuation Web site: http://www.bearval.com/