Review of the Previous Lecture

• Zero Growth Stocks

• Constant Growth Stocks
• Non-constant Growth Stocks
• Components of Required Return
• Common Stock Features
 Topics under Discussion
• Preferred Stock Features
• The Stock Market
• Net Present Value
– Estimating NPV
– Using NPV
 Preferred Stock Features
• Stock with dividend priority over common
stock, normally with a fixed dividend rate,
sometimes without voting rights.
• Preference means only that the holders of
the preferred shares must receive a
dividend before holders if common shares
are entitled to anything.
 Stated Value
• Preferred shares have stated liquidating
value
• Cash dividend is described in terms of
dollars per share.
 Accumulation of Dividend
• A preferred dividend is not like interest on
a bond. The directors may decide not to
pay the dividends on preferred stock
irrespective of the net income of company.
• Dividends on preferred stock may be
either cumulative or non-cumulative; most
are cumulative
 Accumulation of Dividend
• If preferred stocks are cumulative and are
not paid in a particular year, they will be
carried forward as an arrearage.
• Unpaid preferred dividends are not debts of
the firm. Directors can defer the preferred
dividend indefinitely. However, in this
scenario, common stockholders must also
forego dividends. Sometimes these
delayed payments are compensated by
voting rights.
Is Preferred Stock Debt or Equity?
• Preferred shareholders are only entitled to
receive a stated dividend and they are
only entitled to the stated value of their
shares
• Preferred stocks hold credit ratings much
like bonds
• These are sometimes convertible into
common stock and are often callable.
 The Stock Market
• We know that the shares of stocks are
bought and sold at stock exchanges.
• Stock market consists of:
– Primary Market
– Secondary Market
 The Stock Market
• Primary Market
– The market in which new securities are
originally sold to the investors
– Companies sell securities to raise money
• Secondary Market
– The market in which previously issued
securities are traded among investors
 The Stock Market
• Dealer
– An agent who buys and sells securities from a
maintained inventory
– It stands ready to buy securities from investors
wishing to sell them and sells securities to investors
wishing to buy them
– The price that the dealer wishes to pay is the bid
price and the price at which the dealer sells the
securities is called the ask price.
– The difference between the bid and ask price is
called the spread
 The Stock Market
• Broker
– An agent who arranges security transactions
among investors, matching investors wishing
to buy securities with investors wishing to sell
securities
– They do not buy or sell securities for their
own accounts. Facilitating trade between
others is their business
 Capital Budgeting

• What long-term investment should the

firm take on?
 Net Present Value
• An investment is worth undertaking if it
creates value for its owners characterized
by worth in marketplace being more than
what it costs to acquire.
• For example, you buy a run-down house
for $25,000 and spend another $25,000 on
painters, plumbers and so on to get it fixed
up. So your total investment is $50,000.
 Net Present Value
• When the work is completed, you place
the house on the market and find that it is
worth $60,000.
• The market value ($60,000) exceeds the
cost ($50,000) by $10,000.
• If you consider yourself as manager and
have brought together some fixed assets,
labor and material etc., you have created
$10,000 in value.
 Net Present Value
• Now what you as a manager has to do is
to identify the feasibility of investing
$50,000 ahead of time.
• In other words you are trying to determine
whether a proposed investment or project
will be worth more than it costs once it is in
place, a topic we call Capital Budgeting
 Net Present Value
• The difference between an investment’s
market value and its cost is called the net
present value of the investment (NPV).
• Alternatively, NPV is a measure of how
much value is created or added today by
undertaking an investment.
 Net Present Value
• Given our goal of creating value for our
shareholders, the capital budgeting
process can be viewed as a search for
investment with positive net present
values.
• Investment decisions are greatly simplified
when there is a market for assets similar
to the investment we are considering.
 Net Present Value
• Capital budgeting becomes more difficult
when we cant determine the market price
for comparable investment.
• The reason is that we are then faced with
problem of estimating the value of an
investment using only indirect market
information
 Estimating Net Present Value
• If we want to estimate the value of a new
business, say fertilizer, we will
1. Try to estimate the future cash flows we
expect the new business to produce
2. Apply discounted cash flow procedure to
estimate the present value of the cash flows
3. Estimate the difference between the present
value of the future cash flows and the cost of
investment.
– This is know as discounted cash flow
(DCF) valuation.
 Estimating Net Present Value
• Suppose the cash revenues from our
fertilizer business will be $20,000 per year.
• Cash costs (including taxes) will be
$14,000 per year
• The business will be wound up in 8 years
• The plant, property and equipment will
worth $2,000 as salvage value at that
time.
 Estimating Net Present Value
• The project costs $30,000 to launch
• Discount rate on similar projects is 15%
– Is this a good investment?
– What will be the effect on price per share of
1,000 shares from taking the investment?
 Estimating Net Present Value
($000)

Years 0 1 2 3 4 5 6 7 8

Initial
- $30
Cost
Inflows $20 $20 $20 $20 $20 $20 $20 $20
Outflows - 14 - 14 - 14 - 14 - 14 - 14 - 14 - 14
Net
Inflow $ 6 $ 6 $ 6 $ 6 $ 6 $ 6 $ 6 $ 6
Salvage 2
Net Cash
Flow -$30 $ 6 $ 6 $ 6 $ 6 $ 6 $ 6 $ 6 $ 8
 Estimating Net Present Value
• Calculating the present value of the future
cash flows:
PV = $6,000 x (1 – 1/1.158)/0.15 +
2,000 / 1.158
= $6,000 x 4.4873 + 2,000/3.0590
= $26,924 + 654
= $27,578
 Estimating Net Present Value
• Comparing this value with the $30,000
estimated cost, the NPV is;
NPV = -$30,000 + 27,578 = -$2,422
• Therefore this is not a good investment, as
it would decrease the total value of stock
by $2,422.
 Estimating Net Present Value
• With 1,000 shares outstanding, best
estimate of impact of taking up this project
is a loss of value of $2,422/1,000 = $2.422
per share
• Form this example we notice that if NPV is
negative, the effect on share value will be
unfavorable. If NPV were positive, the
effect would be favorable.
 Estimating Net Present Value
• Given that the goal of financial management
is to increase the share value, this discussion
leads to the net present value rule
“An investment should be accepted if
the net present value is positive and
rejected if it is negative.”
• In the unlikely event that NPV is turned out to
be zero, we would be indifferent between
taking and not taking the investment
 Estimating Net Present Value
• Two comments
1. The task of coming up with cash flows and the
discount rate is much more important than the
process of discounting itself.
2. The process of discounting cash flows would
only give us an estimated figure of NPV. The
true NPV can be found by putting the
investment for sale and see what we got for it.
 Summary
• Preferred Stock Features
• The Stock Market
• Net Present Value
– Estimating NPV