BEDER INTERNATIONAL

UNIVERSITY

Course Name: Financial Management II

Semester : 5

© 2003 The McGraw-Hill Companies, Inc. All rights

8.2 Chapter Outline
 Common Stock Valuation
 Common Stock Features
 Preferred Stock Features
 Stock Market Reporting
8.3 Terms
 Proxy A document giving one person the authority to act
for another, typically the power to vote shares of common
stock
 Proxy Fight An attempt by a person or group to gain control
of a firm by getting its stockholders to grant that person or
group the authority to vote its shares to replace the current
management.
 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).
8.4 Terms
 Classified Stock Common stock that is given a special
designation such as Class A or Class B to meet special
needs of the company.
 Dividend Yield The expected dividend divided by the
current price of a share of stock
 Capital Gains Yield The capital gain during a given year
divided by the beginning price.
 Expected Total Return The sum of the expected dividend
yield and the expected capital gains yield.
 Marginal Investor A representative investor whose
actions reflect the beliefs of those people who are currently
trading a stock. It is the marginal investor who determines
a stock’s price.
8.5 Example
 If Company X’s stock is expected to pay a dividend of D1
= $1 during the next 12 months and if X’s current price is
P0 5 $20, what is expected dividend yield?
 If the stock sells for $20.00 today and if it is expected to
rise to $21.00 by the end of the year, what is expected
capital gain?
 what will be Expected total return?
 Example
8.6 – Finding the Required Return
 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?
Div0(1  g)
r g
P0
1.00(1.05)
  0.05
10.50
15%

 What is the dividend yield?  What is the capital gains yield?

Div0(1  g) Capital Gain  g
Dividend Yield 
P0
 0.05
1.00(1.05)

10.50 5%
10%
8.7
Exercise
 What is the holding period return (capital
gains yield) due to the capital gain over the
four-year period where is the current price
is 40 and price expected is 50.5 ?
P1  P0
HPR 
P0
50.50  40.00

40.00
26.25%
8.8 Examples

A firm's stocks is selling for $12they

paid a $2 dividend and dividends are
expected to grow 6% per year.
What is the required return?
Cash
8.9 Flows for Shareholders
 If you buy a share of stock, you can receive cash in two ways
 Dividends
 Selling your shares
 As with any asset, the market price of common stock is equal
to the present value of the expected future cash flows the
stock will generate
 One
8.10 Period Example
 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?
 Compute the PV of the expected cash flows

Div1  Sale Price Calculator Approach

PVStock 
1  r  16 FV
2  14 0 PMT

1.20 1 N
$13.33 20 I
PV $13.33
8.11 Two Period Example
 Now what if you decide to hold the stock for two years? In addition to
the $2 dividend in one year, you expect a dividend of $2.10 in two
years and a stock price of $14.70 at the end of year 2. Now how much
would you be willing to pay now?

Div1 Div2  Sale Price Calculator Approach

PVStock  
1  r  1  r 2 0 CFj
2 2.10  14.70 2 CFj
 
1.20 1.202 16.80 CFj
$13.33 20 I
2nd NPV $13.33
8.12 Three Period Example
 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?

PVStock 
Div1

Div2

Div3  Sale Pr ice Calculator Approach
1  r  1  r 2 1  r 3 0 CFj
2 2.10 2.205  15.435 2 CFj
  
1.20 1.20 2 1.203 2.10 CFj
$13.33 17.64 CFj
20 I
2nd NPV $13.33
8.13 Developing The Model
 We could continue this process for many time periods
 In fact, the price of the stock is just the present value of all
expected future dividends
 So, how can we estimate all future dividend payments?
8.14 Estimating Dividends: Special Cases
 Constant dividend
 The firm will pay a constant dividend forever
 Market instrument – preferred stock
 Price is computed using the level perpetuity formula [PV = C/r]
 Constant dividend growth
 The firm will increase the dividend by a constant percent every
period
 Market instrument – common stock
 Price is computed using a growing perpetuity formula
[PV = C/(r-g)]
 Supernormal growth
 Dividend growth is high initially, but later settles down to a
long-run constant growth rate
8.15 Zero Growth Rate
 The dividends on most preferred stocks are expressed as a constant
percentage of the share’s face value
 Suppose a preferred share is expected to pay a $0.50 dividend every
quarter and the required return is 10% with quarterly compounding.
 What is the price?

Div1
PVPreferred 
Stock r
0.50

 0.10 
 
 4 
$20.00
8.16
practical
example
The current stock of Bedar is $50, if the
require rate of return is 17% what is the
dividend paid by this company, which is not
expected to grow soon?
exercise
Company x stocks is expected to pay a $.50
dividend every semi-annual and the required
return is 10% with semi-annual . What is the
price?
 Constant
8.17 Growth Rate
 To value a common stock, we usually assume the dividend stream will
grow at some constant growth rate over time
Div1 Div 2 Div3 Div 
P0     . . . 
1  r  1  r 2 1  r 3 1  r 
Div 0 1  g  Div 0 1  g  Div 0 1  g  Div 0 1  g 
2 3 
    . . . 
1  r  1  r 2 1  r 3 1  r 

 With a little algebra, this reduces to:

Div 0 (1  g) Div1
P0  
r -g r -g
 Constant
8.18 Growth Rate Example one
 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?

Div 0 (1  g)
P0 
r -g
0.50(1.02)
0.15 - 0.02
$3.92
8.19 Gordon Growth Company – Example 2

Company X is buying stock for

company B which is growing at
constant rate of 6% . Last year the
company paid a dividend of $2.65 .
The required rate of return is 16%.
1. What is the current price for this
stock?
2. What would be the price of the
stock in year 5?
8.20 Example

 Constant growth: Moriband Corp. just

paid a dividend of $2.15 yesterday. The
company is expected to grow at a steady
rate of 5 percent for the foreseeable
future. If investors in stocks of
companies like Moriband require a rate
of return of 15 percent, what should be
the market price of Moriband’s stock?
8.21 exercise

 Constant growth: The required rate of

return is 23 percent. Ninex Corp. has
just paid a dividend of $3.12 and is
expected to grow at a constant rate of 5
percent. What is the expected price of
the stock three years from now?
 Constant
8.22 Growth Rate Example two
 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?

Div1
P0 
r -g
2.00
0.20 - 0.05
$13.33
8.23 Exercise

Bedar have decided to decrease the as

company annual dividend due to
decreasing market share. The last annual
dividend was 2.55 but all future dividend
will decrease by 17 percent annually .
What is a share of this stock worth today
at a required return of 22 %
8.24 Gordon Growth Company – Example 1
 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%.
 What is the current price?

Div1
P0 
r -g
4.00
0.16 - 0.06
$40.00
8.25 Gordon Growth Company – Example 2
 What is the price expected to be in year 4?
Div 5
P4 
r -g
Div1 1  g 
4

r -g
4.001.06
4

0.16 - 0.06
$50.50
8.26 Non-constant Dividend Growth
 Suppose a firm is expected to increase dividends by 20% in
one year and by 15% in year 2. After that, dividends will
increase at a rate of 5% per year indefinitely. If the last
dividend that was just paid was $1 and the required return is
20%, what is the price of the stock?
 Remember that we have to find the PV of all expected future
dividends.
0 20% 1 15% 2 5% 3 5% 4 5%
∞
$1.00
8.27 Exercise

A firm paid a $1 dividend per share to its

common shareholders. Future dividends
are expected to grow a rate of 20% for
each of the next 3 years, and then a
constant rate of 10 percent from the point
on.
1. What price would and investor be
willing to pay 3 years form now if
their required rate of return is 14%?
2. What is stock price?
8.28 Exercise

A firm paid a $2 dividend per share to its

common shareholders. Future dividends
are expected to grow a rate of 20% for
each of the next 4 years, and then a
constant rate of 10 percent from the point
on.
1. What price would and investor be
willing to pay 4 years form now if
their required rate of return is 14%?
2. What is stock price?
8.29 Exercise NONCONSTANT GROWTH VALUATION
Holt Enterprises recently paid a dividend,
D0, of $2.75. It expects to have nonconstant
growth of 18% for 2 years followed by a
constant rate of 6% thereafter. The firm’s
required return is 12%.
a. How far away is the horizon date?
b. What is the firm’s horizon, or continuing,
value?
c. What is the firm’s intrinsic value today,
P 0?
8.30 Exercise NONCONSTANT GROWTH VALUATION
Snyder Computers Inc. is experiencing rapid
growth. Earnings and dividends are expected to
grow at a rate of 15% during the next 2 years, at
13% the following year, and at a constant rate of
6% during Year 4 and thereafter. Its last dividend
was $1.15, and its required rate of return is 12%.
a. Calculate the value of the stock today.
b. Calculate P1 and P2.
c. Calculate the dividend and capital gains yields
for Years 1, 2, and 3
8.31 Gordon Growth Company – Example 2

Reverop, Inc. is a fast-growth stock

expects to grow at rate of 23% for
the next two years. The dividend to be
paid one year from today will be
equal to $4.25. if the required rate of
return 17% , what expectinng price of
stock?
8.32 Common Stock – Features
 Voting Rights
1- Cumulative voting- total number of votes each shareholder may cast =
(# of shares owned) x (# of directors to be elected)
All directors are elected at the same time. Cumulative voting favors minority
stockholders.

2- Straight voting- directors are elected one at a time (i.e., each directors is
voted on one at a time). Straight voting favors majority shareholders.

Staggered elections- only a portion of the board is elected in any one year.
This makes it difficult for minority shareholder to elect a specific director.
8.33 Example- Voting Rights
 A company has two shareholders: “A” (owns 50 shares); “B” (owns 249
shares). There are 5 directors to be elected and 7 candidates running (T, U,
V, W, X, Y, Z). “A” wants candidate Z to be on the board. B wants
candidates T, U, V, W, and Y.
 Using Straight voting- “A” has 50 votes and “B” has 249 votes. Since each
director is voted on one at a time “B” will be able to vote in all his
candidates and “A” will not be able to vote in his candidate.
 Using Cumulative voting-
“A” has 50 x 5 = 250 votes (all for Z)
“B” has 249 x 5 = 1,245 votes (÷ 5 = 249 for T, U, V, W, and Y)

Therefore, Z wins the most votes. “B” cannot arrange votes to block Z.
8.34 Common Stock – Features (cont.)
 Other Rights
 Share proportionally in declared dividends
 Share proportionally in remaining assets during liquidation
 Right to vote on major issues – e.g. mergers
 Preemptive right – the right to purchase new stock to
maintain proportional ownership, if desired (i.e., the right
to buy new shares proportionately)
Example
If an investor has 1% of ownership and 1 million new shares are issued.
The investor will have first rights to buy 10,000 of the new shares.
8.35 Common Stock – Features (cont.)
 Classes of stock- one has voting power, one has high
dividends
 Dual class shares
 Voting & not-voting (restricted)
 Allows founders to retain control while raising new equity
e.g. Class A: 1 vote per share, 100% of dividends
Class B: 10 votes per share, zero dividends (usually not publicly
traded)
8.36 Dividends
 Dividend size is determined by the board of directors
 Dividends are not a liability of the firm until a dividend has
been declared by the board
 Consequently, a firm cannot go bankrupt for not declaring
dividends
 Dividends and Taxes
 Dividend payments are not considered a business expense and
are not tax deductible
 Dividends received by individual shareholders are partially
sheltered by the dividend tax credit (13⅓ %)
 Dividends received by corporate shareholders are not taxed, thus
preventing the double taxation of dividends
8.37 Preferred Stock Valuation
 Preferred stock is a hybrid security with features of bonds and
common stock.
 Its bond features is that preferred stockholders have
preference over common stockholders and have no voting
rights.
 Its common stock features is that dividends on preferred stock
do not have to be paid (i.e., dividends go into arrears and
don’t have to be paid on time).
8.38 Preferred Stock - Characteristics
 Preferred stock has priority over common stock upon
liquidation
 Dividends
 Most preferred stock has a stated dividend that must be
paid before common dividends can be paid
 Dividends are not a liability of the firm and preferred
dividends can be deferred indefinitely
 Most preferred dividends are cumulative – any missed
dividends on preferred stock have to be paid before a
dividend can be paid on common stock
 Preferred stock generally does not carry voting rights
8.39
Problem
Farley Inc. its preferred should pay
a dividend of $10 per year. If its
required return was 10.3%, What is
preferred stock value ?
8.40
Problem
Farley Inc. has perpetual
preferred stock outstanding that
sells for $30 a share and pays a
dividend of $2.75 at the end of
each year. What is the required
rate of return?
8.41
Problem
The constant dividend growth formula P0
= Div1/(r − g) assumes .
A. that dividends grow at a constant rate
g, forever only.
B. g is never negative only.
C. r > g only.
D. D. that dividends grow at a constant
rate g, forever, and r > g only.
8.42
Problem
A Wall Street Journal quotation for a
company has the following values: Div:
$1.12, PE: 18.3, Close: $37.22. Calculate
the approximate dividend payout ratio for
the company.
A. 35 percent
B. 45 percent
C. 55 percent
D. 18 percent