FINC 3330 - Chapter 7 (Equity Markets and Stock Valuation) I. Stock Market Securities A. Common Stock B.

Preferred Stock II. Stock Returns III. Stock Valuation A. Valuation of Common Stock B. Valuation of Preferred Stock

I. Stock Market Securities A. Common Stock is the fundamental ownership claim in a public corporation. Common stock is characterized by: (1) discretionary dividend payments. Common stockholders have no special or guaranteed rights to dividend payments. The major disadvantage of dividend payments is that they are taxed twice (once at the corporation level since dividends are paid from the after-tax income, and once at individual level since individuals must pay personal income taxes on any dividends they receive). As a result, many investors prefer capital gains (increases in the stock price over time), since capital gains have the advantage of being taxed at a lower level. (2) residual claim. Dividends on common stock may be paid only after all creditors and preferred bondholders have been paid. (3) limited liability. Common stockholders losses are limited to the amount invested. (4) voting rights. Common stockholders do not exercise any control over the firm’s daily activities. However, through voting, shareholders can: elect the board of directors; amend the charter on bylaws; approve mergers; authorize different classes of shares. B. Preferred Stock is a hybrid security that has characteristics of both bonds and common stock.. Briefly, these characteristics include: (1) par value; (2) dividend payments – dividend is usually fixed and stated either as a dollar amount or as a percent of face value; (3) preferred stock is senior in the order of claim to common stock but junior to bonds – because of this feature, preferred stock has higher risk than bonds; (4)no voting rights under ordinary circumstances; (5) although taxes on preferred dividends are paid by both the issuer and the investor, corporate investors have the advantage of paying taxes on only 20-30 percent of the preferred dividends received – because of the preferential tax treatment of corporate investors, companies issue preferred stock at lower rates than bonds; as a result, preferred stock is a good investment for corporate investors, however it is a poor investment for individual investors since for higher risk they receive a lower after-tax yield than for bonds. II. Stock Returns The annual percentage return on a stock is: R(%) = Capital Gains Yield + Dividend Yield, where: Capital Gains Yield = (P1- P0)/ P0, Dividends Yield = D1/ P0, with P1 the stock price at the end of the year; P0 the stock price in the beginning of the year; and D1 the annual dividend received by the shareholder.

III. Stock Valuation A. Valuation of Common Stock In order to determine the value of common stock, we will consider three situations: (1) Zero Growth in Dividends Forever. (D=D0= D1= D2=…= Dt=…). In this case, the stock is valued as a perpetuity. (2) Constant Growth in Dividends (Gordon Model). (In any period t, Dt = D0*(1+g)t). In order to use this model, the company must have dividends and r>g. The Gordon Model says that PV = D0*(1+g)/(r-g) = D1/(r-g), where D0 is the current dividend or the dividend that was just paid; D1 is the next expected dividend; r is the required rate of return; g is the growth rate. Using the Gordon Model, we can calculate: a. the required rate of return on the stock: r = (D1 / PV) + g b. the constant growth rate: g = r - (D1 / PV)

Note that for the case of constant growth dividends: g (the constant growth rate) = the capital gains yield. This is only true for the Gordon Model!!! Also note that (D1 / PV) = the dividend yield. (3) Non-Constant Growth in Dividends. Firms often experience periods of non-constant dividend growth, after which the dividend is settled at some constant rate. To obtain the present value of such a stock, you add the present value of the dividends during the non-constant growth period with the present value of the constant growth period. B. Valuation of Preferred Stock: Preferred stock is valued as a perpetuity.

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