The document discusses common stock and preferred stock, including their advantages and disadvantages as sources of financing for corporations and as investments for investors. It also covers topics such as common stock valuation models, rights of common stockholders, characteristics of preferred stock, and how to value preferred stock.

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