1. Financial
Management Chapter 10
Theory and
Practice
Tenth Edition
Stocks and their Valuation
Eugene F. Brigham
Michael C. Ehrhardt
Instructor: Sanam Taimoor
Institute of Business Management

2. Topics
• Advantages and disadvantages of common stock
as a source of fund and investment
• Rights and privileges of common stock holders
• Types of common stock
• Common Stock valuation
• Characteristics of preferred stock
• Evaluation of preferred stock as an investment
and a source of funds
• Understand preferred stock valuation process

3. Stock Financing: Corporations
• Advantages:
– Dividends are not fixed and are not legal
obligations
– Permanent capital equity does not have to be
repaid
• Disadvantages:
– Most expensive form of capital
– Dividends are paid out of after-tax earnings
– Underwriting fees greater than those of debt
– Dilutes ownership and control

4. Stock Financing: Investors
• Advantages:
– Potentially highest return investment for a given
firm
– Taxes can be deferred on price appreciation (due
only when the stock is sold)
– Investors have input regarding company operation

5. Stock Financing: Investor
• Disadvantages:
– Highest risk investment for a given firm
– Dividend payments are not fixed and legal
obligations
– Lowest priority of claims in case of bankruptcy
– The firm has no obligation to repurchase stock

6. Characteristics and Legal Rights
of Common Stockholders
• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors elect management.
• Management’s goal: Maximize stock price.

7. Privileges of Common Stockholders
• Preemptive Right: A provision in the corporate
charter or bylaws that gives common
stockholders the right to purchase on a pro
rata basis new issues of common stock (or
convertible securities).

8. Types of stock market transactions
• Secondary Markets: the market in which
“used” stocks are traded after they have been
issued by corporations
• Primary Markets: the market in which firms
issue new securities to raise corporate capital
– A firm “goes public” through an IPO when the
stock is first offered to the public.

9. Common Stock Valuation
• Valuation Process
– Estimate future cash flows (amt./timing).
– Assess the riskiness of future cash flows.
– Incorporate risk level into the discount rate (adjust
the discount rate).
– Find the present value of future cash flows.

10. Common Stock Valuation
• The value of a share of common stock is equal
to the PV of all future cash flows that it is
expected to provide over the number of years
• What cash flows will a shareholder receive
when owning shares of common stock?
– Future dividends

11. Dividend Valuation Model
• Basic dividend valuation model accounts for
the PV of all future dividends
Div1 Div 2 Div
V 1 2
.......... .
1 ke 1 ke 1 ke
Div t
V t
t 1 1 ke
Divt = Cash Dividend at time t
Ke = Investor’s required rate of return

12. Dividend Growth Pattern Assumptions
• The dividend valuation model requires the
forecast of all future dividends. The following
dividend growth rate assumptions simplify the
valuation process
– Constant Growth
– No Growth
– Growth Phases

13. Constant Growth Model
• The constant growth model assumes that
dividends will grow forever at the rate g
Do 1 g
V
ke g
D1
V
ke g
D1: Dividend paid at time 1.
g: The constant growth rate.
ke: Investor’s required return.

14. Constant Growth Model
• Stock CG has an expected growth rate of 8%.
Each share of stock just received an annual
$3.24 dividend per share. The appropriate
discount rate is 15%. What is the value of the
common stock?
D1 = $3.24 ( 1 + 0.08 ) = $3.50
VCG = D1 / ( ke - g )
= $3.50 / ( 0.15 - 0.08 )
= $50

15. Zero Growth Model
• The zero growth model assumes that
dividends will grow forever at the rate g = 0.
D1
VZG
ke
D1: Dividend paid at time 1.
ke: Investor’s required return.

16. Zero Growth Model
• Stock ZG has an expected growth rate of 0%.
Each share of stock just received an annual $3.24
dividend per share. The appropriate discount
rate is 15%. What is the value of the common
stock?
D1 = $3.24 ( 1 + 0 ) = $3.24
VZG = D1 / ( ke - 0 ) = $3.24 / ( .15 - 0 )
= $21.60

17. Growth Phases Model
• The growth phases model assumes that
dividends for each share will grow at two or
more different growth rates
n t
Do 1 g1 Dn 1 / ks g2
VGP t t
t 1 1 ke t n 1 1 ke

18. Growth Phases Model
• Stock GP has an expected growth rate of 16%
for the first 3 years and 8% thereafter. Each
share of stock just received an annual $3.24
dividend per share. The appropriate discount
rate is 15%. What is the value of the common
stock under this scenario?

19. Growth Phases Model
0 1 2 3 4 5 6
D1 D2 D3 D4 D5 D6
Growth of 16% for 3 years Growth of 8% to infinity!
Stock GP has two phases of growth. The first, 16%, starts at time
t=0 for 3 years and is followed by 8% thereafter starting at time
t=3. We should view the time line as two separate time lines in
the valuation.

20. Growth Phases Model
• Steps to calculate VGP, we take following steps
– Find the annual dividends
– Find the PV of the dividends during the period of
non-constant growth
– Find the price of the stock at the end of the no-
constant growth period and discount this price
back to present
– Add these two components to find the value of
stock

21. Growth Phases Model
• Determine the annual dividends.
D0 = $3.24 (this has been paid already)
D1 = D0(1+g1)1 = $3.24(1.16)1 =$3.76
D2 = D0(1+g1)2 = $3.24(1.16)2 =$4.36
D3 = D0(1+g1)3 = $3.24(1.16)3 =$5.06
D4 = D3(1+g2)1 = $5.06(1.08)1 =$5.46

22. Growth Phases Model
• We determine the PV of cash flows
– PV(D1) = D1(PVIF15%, 1) = $3.76 (.870) = $3.27
– PV(D2) = D2(PVIF15%, 2) = $4.36 (.756) = $3.30
– PV(D3) = D3(PVIF15%, 3) = $5.06 (.658) = $3.33
– P3 = $5.46 / (.15 - .08) = $78 [CG Model]
– PV(P3) = P3(PVIF15%, 3) = $78 (.658) = $51.32
VGP = $3.27+$3.30+$3.33+$51.32
= $61.22

23. Determining the Yield on Common
Stock
• Assuming the constant growth
model, determine the yield on the stock
P0 = D1 / ( ke - g )
Solving for ke such that
ke = ( D1 / P0 ) + g

24. Determining the Yield on Common
Stock
• Assume that the expected dividend (D1) on
each share of common stock is $3. Each share
of common stock is currently trading at $30
and has an expected growth rate of 5%. What
is the yield on common stock?
ke = ($3/$30) + 5%
ke = 15%

25. Preferred Stock
• Characteristics of preferred stock
– Preferred is a hybrid. Preferred dividends are
fixed, but they may be omitted without placing
the firm in default
– Most preferred stocks prohibit the firm from
paying common dividends when the preferred is
in arrears.
– Preferred dividends are usually cumulative, up to
a limit

26. Preferred Stock Financing: Corporations
• Advantages
– Fixed financial cost of equity (fixed amount of
shared profits)
– Avoid danger of bankruptcy
– Limited loss of control
• Disadvantages
– Higher after-tax cost than debt

27. Preferred Stock Financing: Investor
• Advantages
– Steadier more assured income than common
stock
– Preference over common in the event of
liquidation
– Seventy percent of preferred dividends received
by corporations are not taxable
• Disadvantages
– Limited sharing of profits
– No enforceable right to dividends for individuals

28. Preferred Stock Valuation
• Preferred stock pays fixed dividends at regular
intervals has no stated maturity date similar to
a perpetual bond
• Present value of a Preferred stock:-
Divp
Vp
kd
• Yield on Preferred Stock:-
Divp
kp
Vp

29. Preferred Stock Valuation
• Stock PS has an 8%, $100 par value issue
outstanding. The appropriate discount rate is
10%. What is the value of the preferred
stock?
DivP = $100 ( 8% ) = $8.00
kP = 10%.
VP = DivP / kP
= $8.00 / 10%
= $80