Lecture 4 - Stock-Stu

1/29/2018
CAPITAL STRUCTURE
DEBT vs. EQUITY
SOURCES OF FINANCE ‐ STOCK DEBT EQUITY

 Fixed return  Variable return
Financial Management
Contractual interest rate
Dividend only when declared
 Fixed life  Indefinite life
Redeemed on maturity date No maturity date
 Security  Security
Paid before shareholders Residual claim on assets
 No tax exemption
 Tax exemption
Tax shield Income taxed twice
ORDINARY STOCK VALUATION
Share valuation is more difficult than bond
valuation for a number of reasons:
THE STOCK MARKET  uncertainty of promised cash flows
 shares have no maturity
 observing the market rate of return is not
easy.
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ISSUING AND TRADING STOCK TYPES OF STOCK
PREFERRED STOCK
 Stock with dividend priority over common stock, normally
 Stock is issued by public corporations to
with a fixed dividend rate and without voting rights.
finance investments
ranks ahead of common stock for
 Stock is initially issued in the primary
 Dividends
market (IPO)  Payout on liquidation
 Stock is traded in the secondary market  Pays a constant dividend
(NYSE, NASDAQ,…) Generally quoted as a percentage of face value
 Listed vs. over‐the‐counter (OTC) securities Cumulative dividend: If preferred dividend are
cumulative and are not paid in a particular year, they
will be carried forward as an arrearage.
Non cumulative dividend
 No voting power
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TYPES OF STOCK DIVIDEND DISCOUNT MODEL
COMMON STOCK
 Stock that has no special preference either in receiving dividends or Stock price is the present value of expected future
in bankruptcy
cash flows from the shares
 Stockholders are residual claimants – entitled to assets remaining
after debts and preferred stockholders are paid If investors hold shares forever, they are entitled
 Stockholders have the right to: to an infinite stream of dividends
 Vote at company meetings: for BOD, for matters of great importance
such as M&A, new line services…
 Proxy fight
 Redemptive right
 Stockholders benefit in two ways:
 Dividends
Dt is the dividend paid in year t
 Capital gains
 Expected rate of return
Discount rate (r) is the return on
over one period
7 8 Equity – or the opportunity cost
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STOCK VALUATION DIVIDEND DISCOUNT MODELS
The price an investor is willing to pay for a share of Constant dividend (zero growth)
stock depends upon:
The magnitude and timing of expected future
Constant dividend growth
dividends
The risk of the stock
Non‐constant dividend growth (different
The stock’s discount rate is the rate of return growth patterns)
investors can expect to earn on securities with
similar risk
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CASE 1 ‐ CONSTANT DIVIDEND CASE 1 ‐ CONSTANT DIVIDEND MODEL

MODEL (ZERO GROWTH) (ZERO GROWTH) ILLUSTRATION
Ex: RJR Nabisco has a preferred stock outstanding
with an annual dividend of $2.5 per share. If
securities with similar risk are expected to return
9.6% p.a. what is the price of the preferred stock?
Usually for
preferred
stock
valuation
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CASE 2 ‐ CONSTANT DIVIDEND CASE 2 ‐ CONSTANT DIVIDEND GROWTH

GROWTH MODEL MODEL ILLUSTRATION 1
 Suppose Thai airways just paid a dividend of $2.04 per share. Thai airways
expects its profits and dividends to grow at about 7% per year.
If stock holders require a 12% p.a. rate of return – what is the market price of
Thai airways’s stock?
0 1 2 3
2.04 2.04(1.07) 2.04(1.07)2 2.04(1.07)3 ….
What is the market price
of Thai airways’s
common stock in year 4 ?
Need r > g
!!!
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CASE 2 ‐ CONSTANT DIVIDEND CASE 3 : NON‐CONSTANT DIVIDEND

GROWTH MODEL ILLUSTRATION 2 GROWTH MODEL
Suppose Morning Star, Inc., is expected to pay a $2 For some companies, dividends may be expected
dividend in next year. If the dividend is expected to to grow at varying rates:
grow at 5% per year and the required return is 20%, A new company may start with no or low
what is the price ? dividends, gradually move to high dividends, and
settle on relatively constant dividends as the
business matures
Why isn’t the $2 in the numerator multiplied by Relates to the life cycle of the company
(1.05) in this example?
What is the price of Morning Star stock in year 4 ?
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CASE 3 : NON‐CONSTANT DIVIDEND CASE 3 : NON‐CONSTANT DIVIDEND

GROWTH MODEL GROWTH MODEL
 Assume that dividends will grow at different rates in
the foreseeable future and then will grow at a constant
rate thereafter.
 To value a Differential Growth Stock, we need to:
 Estimate future dividends in the foreseeable future.
 Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
 Compute the total present value of the estimated
future dividends and future stock price at the
appropriate discount rate.
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GROWTH MODEL GROWTH MODEL
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GROWTH MODEL GROWTH MODEL ILLUSTRATION
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.
What is the stock worth? The discount rate is 12%.
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GROWTH MODEL ILLUSTRATION GROWTH MODEL ILLUSTRATION
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NON‐CONSTANT DIVIDEND GROWTH NON‐CONSTANT DIVIDEND GROWTH
MODEL CLASS EXERCISE MODEL CLASS EXERCISE
A company has just paid a dividend of 15 cents
per share and that dividend is expected to grow at
a rate of 20 per cent per annum for the next three
years, and at a rate of 5 per cent per annum
forever after that.
Assuming a required rate of return of 10 per cent,
calculate the current market price of the share.
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NON‐CONSTANT DIVIDEND
IN CONCLUSION
GROWTH MODEL CLASS EXERCISE
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COMPONENTS OF THE REQUIRED
COMPREHENSIVE EXAMPLE
RETURN
Growth rate 1. The common stock of IKEA furnishings has a 3.5%
= Capital dividend yield. You expect the company to grow by 6%
gain yield
annually. What is the required return on this stock?
 Answer:
2. The common stock of Nike has a market rate of return
of 17.5% and the market price of $15.00 per share. Nike
Dividend yield
will pay their annual dividend next week in the amount
of $2.1 per share. What is the capital gain yield on this
stock?
 Answer:
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ESTIMATE DIVIDEND GROWTH (g) ESTIMATE DIVIDEND GROWTH (g)
Preliminaries:  If not all earnings are paid as dividends (DPS/EPS <1)
EPS (Earnings per Share)  Then the excess cash (EPS‐DPS) can be reinvested
Net earnings attributable to each common stockholder
 Reinvested cash will earn ROE
 So earnings will grow by (EPS‐DPS)* ROE
 Implying a growth rate of
DPS (Dividends per share)
Dividend paid to stockholder for each share held ( EPS  DPS )  DPS 
g  ROE  1    ROE
EPS  EPS 
Plow‐back ratio
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ILLUSTRATION MODEL OF DIVIDEND GROWTH
GlaxoSmithKline (GSK) corporation
EPS = 10.49 ₡
EPS 10.49 ₡ Payout 76.3% Plow back 23.7%
DPS 8 ₡
DPS = 8 ₡ Retained profit = 2.49 ₡
ROE 9.32% (estimated)
Share price $1.15
Reinvest at ROE = 9.32%
Growth = 0.23 ₡
(g = 2.21%=23.7%*9.32%)
Growth rate = Return on Equity * Plowback ratio
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1/29/2018

SOURCES OF FINANCE ‐ STOCK DEBT EQUITY

CASE 1 ‐ CONSTANT DIVIDEND CASE 1 ‐ CONSTANT DIVIDEND MODEL

CASE 2 ‐ CONSTANT DIVIDEND CASE 2 ‐ CONSTANT DIVIDEND GROWTH

CASE 2 ‐ CONSTANT DIVIDEND CASE 3 : NON‐CONSTANT DIVIDEND

CASE 3 : NON‐CONSTANT DIVIDEND CASE 3 : NON‐CONSTANT DIVIDEND

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