BMGT-ch8.ppt

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  • Dividend exclusion: If corporation A owns less than 20% of corporation B stock, then 30% of the dividends received from corporation B are taxable. If A owns between 20% and 80% of B, then 20% of the dividends received are taxable. If A owns more than 80%, a consolidated statement can be filed and dividends received from B are essentially untaxed.
  • Remind the students that if dividends are paid quarterly, then the discount rate must be a quarterly rate.
  • As the growth rate approaches the required return, the stock price increases dramatically.
  • As the required return approaches the growth rate, the price increases dramatically. This graph is a mirror image of the previous one.
  • Point out that the formula is completely general. The dividend in the numerator is always for one period later than the price we are computing. This is because we are computing a Present Value, so we have to start with a future cash flow. This is very important when discussing supernormal growth. We know the dividend in one year is expected to be $4 and it will grow at 6% per year for four more years. So, D 5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06) 4
  • Point out that P 2 is the value, at year 2, of all expected dividends year 3 on. The final step is exactly the same as the 2-period example at the beginning of the chapter. We can look at as if we buy it today receive the $1.20 dividend in 1 year, receive the $1.38 dividend in 2 years and then immediately sell it for $9.66.
  • Zero growth – 2 / .15 = 13.33 Constant growth: 2(1.03) / (.15 - .03) = $17.17
  • Point out that D 1 / P 0 is the dividend yield and g is the capital gains yield
  • Dealer: maintains an inventory and stands ready to trade at quoted bid (price at which they will buy) and ask (price at which they will sell) prices. Make their profit from the difference between the bid and ask prices, called the bid-ask spread. The smaller the spread the more competition and the more liquid the stock. The move to decimalization allows for a smaller bid-ask spread. There will be more discussion of this later. Broker: a broker matches buyers and sellers. They perform the search function for a fee (commission). They do not hold an inventory of securities. Video: The Financial Markets video discusses how capital is raised in the market and shows the open-outcry market at the CBOT. www: Check out the NYSE by clicking on the web surfer. Students are often amazed at all of the information that is available. NYSE: Specialists manage the order flow by keeping the limit order book. The limit order book lists the trades that investors have given to their brokers that include desired trading prices. The specialist is also a dealer that holds an inventory in their assigned stock, they post bid and ask prices and they are supposed to maintain and orderly market. Other participants on the floor of the exchange include floor traders that own exchange seats, commission brokers and floor brokers.
  • Point out that the NASDAQ market site in Times Square is NOT an exchange. It is just offices and basically a place for reporters to report on what is happening with NASDAQ stocks.
  • This quote is the Harris quote from Figure 8.2 in the text. YTD % Change = -3.3% 52 week high = 33.25 52 week low = 20.75 Company is Harris Corporation Ticker is HRS Annual dividend = $.20 per share Dividend yield = .7% P/E ratio = 87 Volume = 3358*100 = 335,800 shares Closing price = 29.60 Change from previous day is +.50. This means the closing price the day before was 29.60 - .50 = 29.10
  • r = [1.5(1.05)/18.75] + .05 = 13.4%
  • BMGT-ch8.ppt

    1. 1. Chapter 8 STOCKS AND THEIR VALUATION <ul><li>Common Stock Valuation </li></ul><ul><li>Some Features of Common and Preferred Stocks </li></ul><ul><li>The Stock Markets </li></ul><ul><li>Efficient Markets </li></ul><ul><li>Stock Indexes – see chapter 12 </li></ul>
    2. 2. Key Concepts and Skills <ul><li>Understand how stock prices depend on future dividends and dividend growth </li></ul><ul><li>Be able to compute stock prices using the dividend growth model </li></ul><ul><li>Understand how corporate directors are elected </li></ul><ul><li>Understand how stock markets work </li></ul><ul><li>Understand how stock prices are quoted </li></ul>
    3. 3. Facts about Common Stock: <ul><li>Represents ownership . </li></ul><ul><li>Ownership implies control . </li></ul><ul><li>Stockholders elect directors . </li></ul><ul><li>Directors elect management. </li></ul><ul><li>Management’s goal: Maximize stock price. </li></ul><ul><li>Piece of paper </li></ul><ul><li>entitles owner to dividends - if company earns profit & decides to pay dividends - not like bond with contract - promise to pay interest - or DEFAULT </li></ul><ul><li>can be sold at future date - hopefully for a capital gain </li></ul><ul><li>hence price of common stock is the present value of those expected cash flows </li></ul><ul><li>preemptive right - shareholders can purchase additional shares - so less dilution & maintain control </li></ul><ul><li>Voting rights </li></ul>
    4. 4. Advantages of Financing with Stock: <ul><li>No required fixed payments. </li></ul><ul><li>No maturity. </li></ul><ul><li>Improves debt ratio, fixed charge coverage. </li></ul><ul><li>if prospects look bright, comm. stock can be sold on better terms than debt </li></ul><ul><li>finance with common stock during good times to maintain reserve borrowing capacity </li></ul>
    5. 5. Disadvantages of Financing with Stock: <ul><li>Controlling shareholders may lose some control. </li></ul><ul><li>Future earnings shared with new stockholders. Dilution. </li></ul><ul><li>Higher flotation costs vs. debt. </li></ul><ul><li>Higher component cost of capital. </li></ul><ul><li>Too little debt may encourage a takeover bid. </li></ul><ul><li>taxation - dividends doubly taxed </li></ul>
    6. 6. Cash Flows for Stockholders <ul><li>If you buy a share of stock, you can receive cash in two ways </li></ul><ul><ul><li>The company pays dividends </li></ul></ul><ul><ul><li>You sell your shares, either to another investor in the market or back to the company </li></ul></ul><ul><li>As with bonds, the price of the stock is the present value of these expected cash flows </li></ul>
    7. 7. Dividend Characteristics <ul><li>Dividends are not a liability of the firm until a dividend has been declared by the Board </li></ul><ul><li>Consequently, a firm cannot go bankrupt for not declaring dividends </li></ul><ul><li>Dividends and Taxes </li></ul><ul><ul><li>Dividend payments are not considered a business expense, therefore, they are not tax deductible </li></ul></ul><ul><ul><li>Dividends received by individuals are taxed as ordinary income but at a maximum of 15% since tax changes of 2003 </li></ul></ul><ul><ul><li>Dividends received by corporations have a minimum 70% exclusion from taxable income </li></ul></ul>
    8. 8. Financial asset values: 9 Value CF 1 CF n CF 2 0 1 2 n R
    9. 9. One Period Example <ul><li>Suppose you are thinking of purchasing the stock of Moore Oil, Inc. and you expect it to pay a $2 dividend in one year and you believe that you can sell the stock for $14 at that time. If you require a return of 20% on investments of this risk, what is the maximum you would be willing to pay? </li></ul><ul><ul><li>Compute the PV of the expected cash flows </li></ul></ul><ul><ul><li>Price = (14 + 2) / (1.2) = $13.33 </li></ul></ul><ul><ul><li>Or FV = 16; I/Y = 20; N = 1; CPT PV = -13.33 </li></ul></ul>
    10. 10. Two Period Example <ul><li>Now what if you decide to hold the stock for two years? In addition to the dividend in one year, you expect a dividend of $2.10 in and a stock price of $14.70 at the end of year 2. Now how much would you be willing to pay? </li></ul><ul><ul><li>PV = 2 / (1.2) + (2.10 + 14.70) / (1.2) 2 = 13.33 </li></ul></ul><ul><ul><li>Or CF 0 = 0; C01 = 2; F01 = 1; C02 = 16.80; F02 = 1; NPV; I = 20; CPT NPV = 13.33 </li></ul></ul>
    11. 11. Three Period Example <ul><li>Finally, what if you decide to hold the stock for three periods? In addition to the dividends at the end of years 1 and 2, you expect to receive a dividend of $2.205 at the end of year 3 and a stock price of $15.435. Now how much would you be willing to pay? </li></ul><ul><ul><li>PV = 2 / 1.2 + 2.10 / (1.2) 2 + (2.205 + 15.435) / (1.2) 3 = 13.33 </li></ul></ul><ul><ul><li>Or CF 0 = 0; C01 = 2; F01 = 1; C02 = 2.10; F02 = 1; C03 = 17.64; F03 = 1; NPV; I = 20; CPT NPV = 13.33 </li></ul></ul>
    12. 12. Developing The Model <ul><li>You could continue to push back when you would sell the stock </li></ul><ul><li>You would find that the price of the stock is really just the present value of all expected future dividends </li></ul><ul><li>So, how can we estimate all future dividend payments? </li></ul>
    13. 13. Estimating Dividends: Special Cases <ul><li>Constant dividend </li></ul><ul><ul><li>The firm will pay a constant dividend forever </li></ul></ul><ul><ul><li>This is like preferred stock </li></ul></ul><ul><ul><li>The price is computed using the perpetuity formula </li></ul></ul><ul><li>Constant dividend growth </li></ul><ul><ul><li>The firm will increase the dividend by a constant percent every period </li></ul></ul><ul><li>Supernormal growth </li></ul><ul><ul><li>Dividend growth is not consistent initially, but settles down to constant growth eventually </li></ul></ul>
    14. 14. Zero Growth <ul><li>If dividends are expected at regular intervals forever, then this is like preferred stock and is valued as a perpetuity </li></ul><ul><li>P 0 = D / R </li></ul><ul><li>Suppose stock is expected to pay a $0.50 dividend every quarter and the required return is 10% with quarterly compounding. What is the price? </li></ul><ul><ul><li>P 0 = .50 / (.1 / 4) = .50/.025 = $20.00 </li></ul></ul>
    15. 15. For a constant growth stock, If g is constant, then:
    16. 16. Dividend Growth Model <ul><li>Dividends are expected to grow at a constant percent per period. </li></ul><ul><ul><li>P 0 = D 1 /(1+R) + D 2 /(1+R) 2 + D 3 /(1+R) 3 + … </li></ul></ul><ul><ul><li>P 0 = D 0 (1+g)/(1+R) + D 0 (1+g) 2 /(1+R) 2 + D 0 (1+g) 3 /(1+R) 3 + … </li></ul></ul><ul><li>With a little algebra, this reduces to: </li></ul>
    17. 17. $ 0.25 Years (t) 0 ^ If Rs< g, get negative stock price, which is nonsense. We can’t use model unless (1) Rs> g and (2) g is expected to be constant forever.
    18. 18. DGM – Example 1 <ul><li>Suppose Big D, Inc. just paid a dividend of $.50. It is expected to increase its dividend by 2% per year. If the market requires a return of 15% on assets of this risk, how much should the stock be selling for? </li></ul><ul><li>P 0 = .50(1+.02) / (.15 - .02) = $3.92 </li></ul>
    19. 19. DGM – Example 2 <ul><li>Suppose TB Pirates, Inc. is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 20%, what is the price? </li></ul><ul><ul><li>P 0 = 2 / (.2 - .05) = $13.33 </li></ul></ul><ul><ul><li>Why isn’t the $2 in the numerator multiplied by (1.05) in this example? </li></ul></ul>
    20. 20. Stock Price Sensitivity to Dividend Growth, g D 1 = $2; R = 20%
    21. 21. Stock Price Sensitivity to Required Return, R D 1 = $2; g = 5%
    22. 22. Example 8.3 Gordon Growth Company - I <ul><li>Gordon Growth Company is expected to pay a dividend of $4 next period and dividends are expected to grow at 6% per year. The required return is 16%. </li></ul><ul><li>What is the current price? </li></ul><ul><ul><li>P 0 = 4 / (.16 - .06) = $40 </li></ul></ul><ul><ul><li>Remember that we already have the dividend expected next year, so we don’t multiply the dividend by 1+g </li></ul></ul><ul><ul><li>What is D o ? D o = D 1 /(1.06) = 4/1.06= 3.77 </li></ul></ul>
    23. 23. Example 8.3 – Gordon Growth Company - II <ul><li>What is the price expected to be in year 4? </li></ul><ul><ul><li>P 4 = D 4 (1 + g) / (R – g) = D 5 / (R – g) </li></ul></ul><ul><ul><li>P 4 = 3.77(1+.06) 5 / (.16 - .06) = 50.50 = </li></ul></ul><ul><ul><li>P 4 = (3.77)(1.34) / (.16 - .06) = 50.50 </li></ul></ul><ul><ul><li>P 4 = 5.05 / (.16 - .06) = 50.50 </li></ul></ul><ul><ul><li>P 4 = 4(1+.06) 4 / (.16 - .06) = 50.50 </li></ul></ul><ul><li>What is the implied return given the change in price during the four year period? </li></ul><ul><ul><li>50.50 = 40(1+return) 4 ; return = 6% </li></ul></ul><ul><ul><li>PV = -40; FV = 50.50; N = 4; CPT I/Y = 6% </li></ul></ul><ul><li>The price grows at the same rate as the dividends </li></ul>
    24. 24. Nonconstant Growth Problem Statement <ul><li>Suppose a firm is expected to increase dividends by 20% in one year and by 15% in two years. After that dividends will increase at a rate of 5% per year indefinitely. If the last dividend was $1 and the required return is 20%, what is the price of the stock? </li></ul><ul><li>Remember that we have to find the PV of all expected future dividends. </li></ul>
    25. 25. Nonconstant Growth – Example Solution <ul><li>Compute the dividends until growth levels off </li></ul><ul><ul><li>D 1 = 1(1.2) = $1.20 </li></ul></ul><ul><ul><li>D 2 = 1.20(1.15) = $1.38 </li></ul></ul><ul><ul><li>D 3 = 1.38(1.05) = $1.449 </li></ul></ul><ul><li>Find the expected future price </li></ul><ul><ul><li>P 2 = D 3 / (R – g) = 1.449 / (.2 - .05) = 9.66 </li></ul></ul><ul><li>Find the present value of the expected future cash flows </li></ul><ul><ul><li>P 0 = 1.20 / (1.2) + (1.38 + 9.66) / (1.2) 2 = 8.67 </li></ul></ul>
    26. 26. Quick Quiz – Part I <ul><li>What is the value of a stock that is expected to pay a constant dividend of $2 per year if the required return is 15%? </li></ul><ul><li>What if the company starts increasing dividends by 3% per year, beginning with the next dividend? The required return stays at 15%. </li></ul>
    27. 27. Using the DGM to Find R <ul><li>Start with the DGM: </li></ul>
    28. 28. Finding the Required Return - Example <ul><li>Suppose a firm’s stock is selling for $10.50. They just paid a $1 dividend and dividends are expected to grow at 5% per year. What is the required return? </li></ul><ul><ul><li>R = [1(1.05)/10.50] + .05 = 15% </li></ul></ul><ul><li>What is the dividend yield? </li></ul><ul><ul><li>1(1.05) / 10.50 = 10% </li></ul></ul><ul><li>What is the capital gains yield? </li></ul><ul><ul><li>g =5% </li></ul></ul>
    29. 29. Table 8.1 - Summary of Stock Valuation
    30. 30. Stock Market <ul><li>Dealers vs. Brokers </li></ul><ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>Largest stock market in the world </li></ul></ul><ul><ul><li>Members </li></ul></ul><ul><ul><ul><li>Own seats on the exchange </li></ul></ul></ul><ul><ul><ul><li>Commission brokers </li></ul></ul></ul><ul><ul><ul><li>Specialists </li></ul></ul></ul><ul><ul><ul><li>Floor brokers </li></ul></ul></ul><ul><ul><ul><li>Floor traders </li></ul></ul></ul><ul><ul><li>Operations </li></ul></ul><ul><ul><li>Floor activity </li></ul></ul>
    31. 31. NASDAQ <ul><li>Not a physical exchange – computer based quotation system </li></ul><ul><li>Multiple market makers </li></ul><ul><li>Electronic Communications Networks </li></ul><ul><li>Three levels of information </li></ul><ul><ul><li>Level 1 – median quotes, registered representatives </li></ul></ul><ul><ul><li>Level 2 – view quotes, brokers & dealers </li></ul></ul><ul><ul><li>Level 3 – view and update quotes, dealers only </li></ul></ul><ul><li>Large portion of technology stocks </li></ul>
    32. 32. Work the Web Example <ul><li>Electronic Communications Networks provide trading in NASDAQ securities </li></ul><ul><li>The Island allows the public to view the “order book” in real time </li></ul><ul><li>Click on the web surfer and visit The Island! </li></ul>
    33. 33. Reading Stock Quotes <ul><li>Sample Quote </li></ul><ul><li>-3.3 33.25 20.75 Harris HRS .20 .7 87 3358 29.60 +0.50 </li></ul><ul><li>What information is provided in the stock quote? </li></ul><ul><li>Click on the web surfer to go to CNBC for current stock quotes. </li></ul>
    34. 34. Quick Quiz – Part II <ul><li>You observe a stock price of $18.75. You expect a dividend growth rate of 5% and the most recent dividend was $1.50. What is the required return? </li></ul><ul><li>What are some of the major characteristics of common stock? </li></ul><ul><li>What are some of the major characteristics of preferred stock? </li></ul>
    35. 35. Holders of Corporate Equity Securities ( June 30, 1995)
    36. 36. Holders of Corporate Equity Securities ( September 30, 1998)
    37. 37. <ul><li>Dividend growth model </li></ul><ul><li>Free cash flow method </li></ul><ul><li>Using the multiples of comparable firms </li></ul>Different Approaches for Valuing Common Stock
    38. 38. some stock market index values 3/24/03 & 10/26/99 <ul><li>DJIA 3/24/03 8214.68 - 307.29 -3.61% </li></ul><ul><li>S& P 500 864.23 - 31.56 -3.52% </li></ul><ul><li>NASDAQ comp 1369.78 - 52.02 -3.66% </li></ul><ul><li>Russell 2000 367.25 - 2.39 -2.39% </li></ul><ul><li>NYSE comp. 4801.58 -129.36 -3.41% </li></ul><ul><li>Wilshire 5000 8180.45 -282.87 -3.34% </li></ul><ul><li>------------------------------------------------------------------------------------------------------------ </li></ul><ul><li>DJIA 10/26/99 10349.93 - 120.32 - 1.15% </li></ul><ul><li>S& P 500 1293.63 - 6.69 - 8.02% </li></ul><ul><li>NASDAQ comp 2815.95 - 0.57 - 0.02% </li></ul><ul><li>Russell 2000 417.76 - 0.93 - 0.22% </li></ul><ul><li>NYSE comp. 597.31 - 3.85 - 0.64% </li></ul><ul><li>Wilshire 5000 11825.20 - 50.00 - 0.42% </li></ul>
    39. 39. Stocks in DJIA as of 11/1/99 <ul><li>Company market value in billions </li></ul><ul><li>Microsoft $486.19 </li></ul><ul><li>General Electric 416.79 </li></ul><ul><li>Intel Corp. 253.50 </li></ul><ul><li>Wal-Mart Stores, Inc. 237.17 </li></ul><ul><li>Merck & Co., Inc. 183.98 </li></ul><ul><li>Exxon Corp. 175.42 </li></ul><ul><li>IBM Corp. 172.88 </li></ul><ul><li>Citigroup 169.50 </li></ul><ul><li>Johnson & Johnson 141.84 </li></ul><ul><li>AT&T Corp 141.81 </li></ul><ul><li>Coca Cola 138.74 </li></ul><ul><li>Proctor & Gamble 131.32 </li></ul><ul><li>Home Depot 109.19 </li></ul><ul><li>SBC Communication 90.25 </li></ul><ul><li>Hewlett Packard 78.58 </li></ul>
    40. 40. Stocks in DJIA as of 11/1/99 <ul><li>Company market value in billions </li></ul><ul><li>DuPont $ 66.89 </li></ul><ul><li>American Express 65.40 </li></ul><ul><li>Philip Morris Co. 61.55 </li></ul><ul><li>Walt Disney Co. 53.88 </li></ul><ul><li>McDonald’s Corp. 53.60 </li></ul><ul><li>Boeing Co. 43.16 </li></ul><ul><li>General Motors Corp. 42.72 </li></ul><ul><li>Minnesota Mining & Mfg. 38.02 </li></ul><ul><li>Allied Signal Inc. 28.82 </li></ul><ul><li>United Technologies Corp. 26.87 </li></ul><ul><li>ALCOA Inc. 23.01 </li></ul><ul><li>Eastman Kodak 21.62 </li></ul><ul><li>JP Morgan & Co. 21.60 </li></ul><ul><li>International Paper 20.16 </li></ul><ul><li>Caterpillar Inc. 19.58 </li></ul><ul><li>in 1999 - 27% mfg., 33% consumer, 27% technology, 10% financial, 3% energy; in 1979 57% mfg., 23% consumer, 10% technology/, 10% energy </li></ul>

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