Essentials of Corporate Finance 9th Edition Ross Solutions Manual

Essentials of Corporate Finance 9th
Edition Ross Solutions Manual

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Chapter 07 – Equity Markets and Stock Valuation
Chapter 7
EQUITY MARKETS AND STOCK VALUATION
Equity Markets and Stock Valuation
Slide
7 Chapter Organization Number
Slide Title
Introduction 7.2 Key Concepts and Skills

7.3 Chapter Outline
7.1 Common Stock Valuation
Cash Flows 7.4 Cash Flow for Stockholders
7.5 One Period Example
7.6 One Period Example
7.7 Two Period Example
7.8 Three Period Example
7.9 Three Period Example
7.10 Develop the Model
7.11 Stock Value = PV of Dividends
Some Special Cases 7.12 Estimating Dividends - Special Cases
7.13 Zero Growth
7.14 Constant Growth Stock
7.15 Projected Dividends
7.16 Dividend Growth Model
7.17 DGM - Example 1
7.18 DGM - Example 2
7.19 Stock Price Sensitivity to Dividend Growth, g
7.20 Stock Price Sensitivity to Required Return, R
7.21 Example 7.3 - Gordon Growth Company - I
7.22 Example 7.3 - Gordon Growth Company - II
7.23 Example 7.3 - Gordon Growth Company - II
7.24 Constant Growth Model Conditions
7.25 Nonconstant Growth
7.26 Nonconstant Growth - Solution
7.27 Nonconstant + Constant Growth
7.28 Nonconstant + Constant Growth
7.29 Nonconstant Growth followed by Constant Growth
7.30 Quick Quiz: Part 1
Components of the Required Return 7.31 Using the DGM to Find R
7.32 Finding the Required Return - Example
7.35 Valuation with Multiples
7.36 Valuation with Multiples - Example
7.37 Table 7.1
Some Features of Common and
7.2
Preferred Stock
Common Stock Features 7.38 Features of Common Stock
7.39 Features of Common Stock
7.40 Dividend Characteristics
Preferred Stock Features 7.41 Features of Preferred Stock
7.3 The Stock Markets
Dealers & Brokers 7.42 The Stock Markets
Organization of the NYSE 7.43 New York Stock Exchange (NYSE)
7.44 NYSE Operations
NASDAQ Operations 7.45 NASDAQ
7.46 ECNs
Stock Market Reporting 7.47 Reading Stock Quotes
7.48 Work the Web
7.51 Chapter 7 END
Copyright (c) 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior
written consent of McGraw-Hill Education.
7-1
CHAPTER WEBSITES
Websites may be referenced more than once in a chapter. This table just includes the
section for the first reference.
Chapter Section Web Address

7.1 www.fool.com/school/earningsbasedvaluations.htm
7.3 www.nyse.com
money.cnn.com
www.nasdaq.com
www.batstrading.com
finance.yahoo.com
ANNOTATED CHAPTER OUTLINE
Slide 7.2 Key Concepts and Skills
Slide 7.3 Chapter Outline

Stock valuation is more difficult than bond valuation because the cash flows are
uncertain, the life is forever, and the required rate of return is unobservable. Common
stock has no maturity date because it represents shares of ownership in a corporation
that, as a legal entity, has an infinite life span.
Slide 7.4 Cash Flow to Stockholders

The cash flows to stockholders consist of dividends plus a future sale price. However,
the future sale price depends on the dividends paid after that point. Therefore, the
current stock price is ultimately the present value of all expected future dividends.
Cash flows are discounted at the required return, R, which, in equilibrium, is the same
as the ―expected return.‖
P0 = D1/(1 + R) + D2/(1 + R)2 + D3/(1 + R)3 + …
Shareholders receive returns on common stock in two ways:

Cash = Dividends
Capital gains = Selling price per share minus purchase price per share (P1 – P0)
Slide 7.5 One-Period Example

Slide 7.6 One-Period Example—Solution
Slide 7.5 Describes the problem.
Slide 7.6 Note that the period 1 cash flow includes both the dividend AND the
selling price. Also, stress that the dividend given in the problem is the EXPECTED
dividend at time t = 1.
7-2
Slide 7.7 Two-Period Example

This extends the one-period example to holding the same stock for two periods.
Again, the calculations are straightforward present value calculations.
Price is still $13.33.
Slide 7.8 Three-Period Example

Extending again to three periods, and the price remains the same—$13.33.
Slide 7.9 Three-Period Example—TI BAII+ CF Worksheet Solution

Because students were introduced to the TI BAII+’s Cashflow Worksheet in Chapter
5, this offers an example of the use of this functionality.
Slide 7.10 Developing the Model

Leads into the basic PV formula to value stock.
Slide 7.11 Stock Value = PV of Dividends

This slide introduces the basic formula for valuing common stock as the present value
of all future dividends. Clearly the infinity sign presents a problem in actually
applying the formula, so some special case assumptions need to be made. (next slide)
Lecture Tip: As the text points out, a stock that currently pays no dividends may or
may not have value; a stock that will NEVER pay a dividend cannot have any value
as long as investors are rational. For a stock that currently pays no dividend, market
value derives from (1) the hope of future dividends and/or (2) the expectation of a
liquidating dividend. In the latter case, ―never pays a dividend‖ really means ―never
pays out cash in any form‖ to shareholders. Students will often argue strenuously
that a firm never has to pay a dividend because investors can just rely on the increase
in price.
Emphasize that the price won’t continue to increase forever. The company will
eventually run out of productive ways to use its cash. When this happens, it will need
to begin paying dividends.
Another way to think of this is that a company that never pays a dividend, including a
liquidating dividend, is essentially a perpetual zero coupon bond. It is a black hole
where you put money in but you never get anything back out.
FedEx provides an example of a firm beginning to pay a quarterly dividend after a

long period of no dividends. Until 2002, FedEx paid no dividends, finding excellent
investment opportunities for its earnings. On May 31, 2002, FedEx’s Board of
Directors declared its first quarterly dividend of $0.05 per share. This was a
7-3
milestone decision for the company because dividends are considered ―sticky,‖
meaning once a firm starts paying dividends, its shareholders expect them to continue
and for the dividend to grow.
Slide 7.12 Estimating Dividends: Special Cases

Three special cases of assumptions for estimating dividends allow us to value
common stock.

 Constant dividend implies zero dividends growth (constant dollar amount) and
is valued like a perpetuity.
 Constant dividend growth is the most fundamental and frequently used
assumption. It describes a constant dividend growth percent.
 Supernormal growth allows valuation of the stock of a company experiencing
abnormal growth currently but expected to stabilize to a constant growth
situation in the future.
Slide 7.13 Zero Growth

Zero-growth—implies that D0 = D1 = D2 … = D
Because the cash flow is always the same, the PV is that for a perpetuity:
P0 = D / R
Example (on slide): Suppose a stock is expected to pay a $0.50 dividend each
quarter forever, and the required return is 10% compounded quarterly.
What is the stock worth?

P0 = .50 /(.10/4) = .50/.025 = $20
Remind students that if dividends are paid quarterly, then the discount rate must
be a quarterly rate.
Slide 7.14 Constant Growth Stock

―Constant growth‖ means constant PERCENT growth.
The slide shows the dividends stream for a constant growth stock.
Lecture Tip: Emphasize the difference between the dividend just paid (D0) and the
expected dividends (D1 to Dt). The ―just paid‖ dividend is only used to estimate future
dividends. It is NOT used in the PV calculation in any other way, because we are
concerned with future cash flows, not past ones.
Slide 7.15 Projected Dividends

Constant growth—dividends are expected to grow at a constant percentage rate each
period.
7-4
D1 = D0(1+g); D2 = D1(1+g); in general, Dt = D0(1+g)t.
Note, that this is the same as the future value formula.
Knowing the last dividend expected (Dt-1) or the last dividend actually paid (D0) and
the constant growth rate, we can calculate the expected dividend for any future time
period.
Dt = D0 (1+g)t or
Dt = Dt-1(1+g)
Slide 7.16 Dividend Growth Model

Given our basic PV definition and using some advanced mathematics, we can derive
the Dividend Growth Model, also known as the Gordon Growth Model for the
academic who did extensive work in this area.
Again, emphasize the difference between D0 and D1.
Lecture Tip: In his book, A Random Walk Down Wall Street (1985, W.W. Norton &
Company, New York, pp. 82–89), Burton Malkiel gives four ―fundamental‖ rules of
stock prices. Loosely paraphrased, the rules are as follows. Other things equal:
• Investors pay a higher price the larger the dividend growth rate.
• Investors pay a higher price the larger the proportion of earnings paid out as
dividends.
• Investors pay a higher price per share the less risky the company’s stock.
• Investors pay a higher price per share the lower the level of interest rates.
If the required return, R, is looked at as a riskless rate of interest, Rf, plus a risk
premium, RP, (R = Rf + RP), it is easily shown that Malkiel’s rules have counterparts
in the dividend growth model that exert just these effects on stock price.
Of course, the tricky part is estimating the growth rate and required return. So, while
the model is precise, its predictions may be substantially different from observed
stock prices depending on the values used.
Advanced Lecture Tip: If students have had some calculus, it might be useful to
derive the dividend growth model.
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) 3 D0 (1  g ) t
P0     ... 
(1  R ) (1  R ) 2 (1  R ) 3 (1  R ) t
Now multiply both sides by (1+R)/(1+g):

(1  R)  (1  g ) (1  g ) 2 (1  g ) t 1 
P0  D0 1    ...  
(1  g )  (1  R) (1  R)
2
(1  R) t 1 
7-5
Subtract the first equation from the second and you get:
 (1  R)  (1  g )   (1  g ) t 
  0
P  D0 1  t 
 (1  g )   (1  R) 
The term 1 – (1 + g)t/(1 + R)t goes to one as t approaches infinity, assuming R > g.
Solve for P0 to get the dividend growth model.
Slide 7.17 DGM: Example 1

Slide 7.18 DGM: Example 2
Two examples using the DGM to evaluate a stock with a constant dividend growth
rate.
Slide 7.19 Stock Price Sensitivity to Dividend Growth, g

As the growth rate approaches the required return, the stock price increases
dramatically. From the DGM formula, as g → R, the denominator → 0.
Slide 7.20 Stock Price Sensitivity to Required Return, R

As the required return approaches (is decreased leftward toward) the growth rate, the
price increases dramatically. This graph is a mirror image of the previous one.
Slide 7.21 Example 7.3: Gordon Growth Company I

Another example using the DGM.
Point out that the formula is completely general. The dividend in the numerator is
always for one period later than the price we are computing. This is because we are
computing a Present Value, so we have to start with a future cash flow. This is very
important when discussing supernormal growth.
Slide 7.22 Example 7.3: Gordon Growth Company II

We know the dividend in one year is expected to be $4 and it will grow at 6% per
year for four more years. So, D5 = 4(1.06)(1.06)(1.06)(1.06) = 4(1.06)4.
Slide 7.23 Example 7.3: Gordon Growth Company II

Continuing the Gordon Growth Company example, we solve for the implied return.
Point out that the stock price grows at the same rate as the dividend.
Slide 7.24 Constant Growth Model Conditions

These conditions or assumptions must exist to correctly use the DGM.
Lecture Tip: Students often ask:
―How can g ever be assumed to be constant?‖
7-6
The answer lies in the competitive equilibrium model of classical macroeconomics.

Because g represents not only the growth rate in dividends but also in earnings and
sales, assuming no change in the firm’s cost structure, we are simply assuming that
the product market the firm operates in ―settles down‖ to a steady state in which
competing firms earn sufficient returns to remain in business, but not large enough to
attract outside capital. From a more practical standpoint, firms will often attempt to
manage their dividend policy so that there is a reasonably constant growth in
dividends.
―Why do we assume that R > g?‖
At least two answers are possible. First, R may be less than g in the short run. The
supernormal growth problem is an example of this situation. Second, in equilibrium,
high returns on investment will attract capital, which, in the absence of technological
change, will ensure that in succeeding periods, higher returns cannot be earned
without taking greater risk. But taking greater risk will increase R, so g cannot be
increased without raising R.
Note that, from the equation itself, we can see that the growth rate must be less than
the required return else the denominator will be negative leading to a negative—and
impossible—stock price.
Slide 7.25 Nonconstant Growth

This situation is quite common, especially among younger, startup companies that
may experience a high growth spurt tapering off to a stable long-term growth pattern.
While we only look at a two-stage model, it is certainly possible to expand the model
to include three or more stages with different growth rates in each. The underlying
theory is the same.
Slide 7.26 Nonconstant Growth—Solution

Point out that P2 is the value, at year 2, of all expected dividends received in year 3
and later.
The final step is exactly the same as the two-period example at the beginning of the
chapter. If we buy the stock today then we will receive the $1.20 dividend in one
year, receive the $1.38 dividend in two years, and then immediately sell it for $9.66.
Lecture Tip: Students often have difficulty with the timing of the ―price‖ or terminal
value in the nonconstant growth computations. Emphasize that the price always
occurs one period before the dividend in the numerator. Make sure the students
understand that the terminal value includes all the remaining dividends. So, the
nonconstant growth valuation procedure is still just finding the present value of all
expected future dividends.
7-7
Slide 7.27 Nonconstant + Constant Growth

Solving a nonconstant growth problem is really an exercise in using both the basic PV
formula along with the constant dividend growth model in combination.
We have to discount the dividends during the nonconstant period individually. Then
we use the first constant growth dividend to find the price at the end of the
nonconstant period. Discounting each of these cash flows appropriately and summing
results in today’s price.
Slide 7.28 Nonconstant + Constant Growth

This is the specific formulation from slide 7.26 used to solve the problem on slide
7.24.
Slide 7.29 Nonconstant Growth Followed by Constant Growth

It is sometimes easier for students to understand the process if it’s shown on a
timeline. Usually the main problem students have is figuring out which dividend to
use to calculate the terminal price and WHAT price to compute.
Slide 7.30 Quick Quiz: Part 1

Zero growth: 2 / .15 = 13.33
Constant growth: 2(1.03) / (.15 – .03) = $17.17
Slide 7.31 Using the DGM to Find R

Like bonds, we can observe the market price of a share of stock (P0). We can find the
last dividend paid (D0) and can obtain estimates of the growth rate (g). Using these,
we can solve for the market required return on the stock. The market required return
implies that the market is pricing the stock to deliver this return.
Rearrange P0 = D1 / (R – g) to find R:
R = (D1 / P0 ) + g
Dividend yield = D1 / P0
Capital gains yield = g
R = Dividend yield + Capital gains yield
Point out that D1 / P0 is the dividend yield and g is the capital gains yield (percentage
change in the stock price).
Slide 7.32 Finding the Required Return—Example

Slide 7.32 states the problem.
7-8
Slide 7.33 solves the problem using the formula.
Slide 7.34 repeats the solution to emphasize the components of required return:
dividend yield and capital gains yield.
Slide 7.35 Valuation with Multiples

When a stock doesn’t pay dividends, price multiples such as the PE ratio can be used
to price the stock. By multiplying a benchmark PE ratio by a forecasted earnings
value, we can predict the stock price. This method can be used with the price-to-sales
ratio when a company might have negative earnings.
Slide 7.36 Valuation with Multiples—Example
Slide 7.37 Table 7.1: Summary of Stock Valuation
Slide 7.38 Features of Common Stock

Voting Rights:
Shareholders have the right to elect the board of directors and vote on other important
issues.
 Cumulative voting—when the directors are all elected at once. Total votes that
each shareholder may cast equals the number of shares times the number of
directors to be elected. In general, if N directors are to be elected, it takes 1 /
(N + 1) percent of the stock + 1 share to assure a deciding vote for one
directorship. Increases the likelihood of minority shareholder representation
on the board.
 Straight (majority) voting—the directors are elected one at a time, and every
share gets one vote. Can freeze out minority shareholders.
 Staggered elections—directors’ terms are rotated so they aren’t elected at the
same time. This makes it harder for a minority to elect a director and
complicates takeovers.
 Proxy voting—grant of authority by a shareholder to someone else to vote his
or her shares. A proxy fight is a struggle between management and outsiders
for control of the board, waged by soliciting shareholders’ proxies.
Real-World Tip: Students often find a digression on proxy fights interesting. It serves
both to underline the importance of equity voting rights and to introduce the concept
of the market for corporate control.
Consideration of Carl Icahn’s attempt to gain control of Texaco via a 1988 proxy
fight indicates that proxy fights need not be ―successful‖ to benefit shareholders.
Icahn amassed a 14% stake in the firm and offered to buy the remainder for $12.4
billion. Rebuffed by management, he launched a proxy fight that he ultimately lost, in
large part because management was able to mount a successful public relations
7-9
campaign that convinced shareholders that Icahn’s offer was not in their best
interests. Nonetheless, as a result of Icahn’s actions, management undertook a
massive restructuring program that included a drastic reduction in the firm’s debt
load, significantly reduced exploration costs, and the divestiture of assets worth $5
billion. Management’s efforts were so well received in the financial markets that
Icahn stated in 1991: ―Since the proxy fight, [management] woke up. I wish to hell
I’d kept the stock.‖
Lecture Tip: Large institutions, such as mutual funds and pension funds, used to
remain on the sidelines when it came to corporate control. However, several
institutions have become much more active in recent years and have worked to force
companies to operate in the shareholders best interests. CalPERS, the pension plan
for California public employees, has been at the forefront of the corporate
governance movement. Management for the fund takes their job as ―shareowners‖ so
seriously that they have a section of their website devoted to corporate governance
issues.
For more information, see http://www.calpers-governance.org/forumhome.asp.
Classes of Stock:
Different classes of stock can have different rights. Owners may want to issue a
nonvoting class of stock if they want to make sure that they maintain control of the
firm.
 Ford Motor Company has always had two classes of stock: Class B or
―Founders’ Shares‖ are owned by the Ford family and carry 40% of the voting
rights though they represent only 10% of the shares outstanding.
 Google has Class A shares that are publicly traded and carry one vote per
share. Class B shares are held by insiders and carry 10 votes per share.
Slide 7.39 Features of Common Stock—Other Rights

Other rights usually include:
 Sharing proportionately in dividends paid.

 Sharing proportionately in any liquidation value.
 Voting on matters of importance (e.g., mergers).
 The right to purchase any new stock sold – the preemptive right.
Real-World Tip: The importance of the preemptive right was driven home in
November 1996 to the shareholders of Marvel Entertainment Group, the company
that produces Marvel Comics. (Marvel’s stable of characters includes Spider-Man,
the Fantastic Four, and the Incredible Hulk, among others.) Despite Marvel’s
dominance of the comic book market, the declining size of the market, as well as a
heavy debt load, caused Marvel to run the risk of default. In order to obtain needed
funds, Ron Perelman, who (through his other firms) owned approximately 80% of the
7-10
outstanding shares, proposed that Marvel issue 410 million new shares at a price of
$0.85 per share. The effect of the announcement was to drive the price of the
outstanding 20% of the shares Perelman didn’t own from $4.625 to less than $2.50.
To add insult to injury, according to The Wall Street Journal, Perelman had the
power, as the majority shareholder, to force the plan through.
Subsequently, Marvel filed for bankruptcy reorganization and Carl Icahn sought to
gain control of the firm. Ultimately, Marvel merged with Toy Biz, much to Icahn’s
displeasure. The combined company is still Marvel Entertainment and trades under
the ticker symbol MVL.
Slide 7.40 Dividend Characteristics

Payment of dividends is at the discretion of the board. A firm cannot default on an
undeclared dividend, nor be forced to file for bankruptcy because of nonpayment of
dividends.
Dividends are not tax deductible for the paying firm.
Dividends received by individuals are usually considered ordinary income, while

dividends received by a corporation are at least 70% tax-exempt.
Slide 7.41 Features of Preferred Stock

Preferred stock represents equity in the firm but has many features of debt, including
a stated yield, preference in terms of cash flows and liquidation, and some issues are
callable and/or convertible into common shares. In fact, many new issues have
sinking funds that effectively convert what was a perpetual security into an equity
security with a definite maturity. However, for tax purposes, preferred stock is equity,
and dividends are not a tax-deductible expense.
Preferred stock has precedence over common stock in the payment of dividends and
in liquidation. Its dividend is usually fixed, and the stock is often without voting
rights. The stated value is the value paid to preferred stockholders in the event of
liquidation.
Cumulative dividends—current preferred dividend plus all arrearages (unpaid

dividends) to be paid before common stock dividends can be paid. Noncumulative
dividend preferred does not have this feature.
Real-World Tip: A glance at the stock quote pages in The Wall Street Journal
provides evidence that some firms have numerous classes of preferred stock. An
online search for ticker symbols also confirms this (and that some have various
classes of common stock). Students are probably already aware that NASDAQ
common issues outnumber NYSE issues by approximately three to one. The reverse
appears to be true for preferred stock.
7-11
Slide 7.42 The Stock Markets

Primary market—new issue market (IPOs).
Secondary markets—existing shares traded among investors.
Dealers—maintain an inventory and stand ready to trade at quoted bid (price at which
they will buy) and ask (price at which they will sell) prices. They make their profit
from the difference between the bid and ask prices, called the bid-ask spread. The
smaller the spread, the more competition and the more liquid the stock. Think ―used
car dealer.‖
Brokers—match buyers and sellers. They perform the search function for a fee
(commission). They do not hold an inventory of securities. Think ―real estate broker.‖
Slide 7.43 New York Stock Exchange (NYSE) (Web link)

Merged with Euronext in 2007 to form NYSE Euronext. Merged with AMEX in
2008.
Designated market maker (DMM)—NYSE members who act as dealers in particular

stocks. Formerly known as ―specialists.‖
Floor brokers—NYSE members who execute orders for commission brokers on a fee
basis.
Supplemental liquidity providers (SLPs)—investment firms that are active

participants in stocks assigned to them. Their job is to make a one-sided market (i.e.,
offering to either buy or sell). They trade purely for their own accounts
Video Note: The ―Financial Markets‖ video discusses how capital is raised and
shows an open-outcry market at the Chicago Board of Trade.
www: Check out the NYSE website by clicking on the hot link. Students are often
amazed at all of the information that is available.
Slide 7.44 NYSE Operations

Order flow—the flow of customer orders to buy and sell securities.
DMMs:
• Manage the order flow by keeping the limit order book. (The limit order book
lists the trades that investors have given to their brokers that include desired
trading prices.)
• Hold an inventory in their assigned stock, post bid and ask prices, and are
supposed to maintain an orderly market.
• Post is a fixed place on the exchange floor where the DMM operates.
7-12
Trading in ―the crowd‖—trading that occurs directly between brokers around the
DMM’s post.
Lecture Tip: The role of the DMM is an interesting one. He or she is entrusted with
the knowledge of pending buy and sell orders (in other words, the DMM knows the
shapes of the market supply and demand curves) for the stock he or she deals in and
is to provide liquidity and continuity in pricing by buying when the market is selling
and selling when the market is buying. Interestingly, while studies performed in the
early 1970s indicated that specialists (DMMs) were able to earn excess returns,
studies of the crash of 1987 suggest that specialists were unable (and, in some cases,
unwilling) to buy as the market crashed on October 19. And in the April 24, 1998,
issue of Money Daily, John Gutfreund, former Salomon Brothers CEO, states that he
―is not certain that the obligation of the market markers is to anyone other than
themselves.‖ For these reasons, among others, some who study markets question the
efficacy of the DMM system.
Slide 7.45 NASDAQ (Web link)

NYSE operations represent a premier example of the trading of ―listed‖ securities.
NASDAQ operations, on the other hand, represent the evolution of ―over-the-
counter‖ trading of securities that does not rely on a physical market place.
NASDAQ—National Association of Securities Dealers Automated Quotation

system—computer network of securities dealers who disseminate timely security
price quotes to NASDAQ subscribers.
NASDAQ is a multiple market maker system with many dealers ―making a market‖
in the same stock.
NASDAQ merged with OMX in 2007.
www: Check out the NASDAQ website by clicking on the hot link.
Slide 7.46 ECNs

ECN—electronic communications network.
An ECN is a website that allows trading directly between investors without using
either a dealer or a broker
Grew to prominence in the late 1990s.
Slide shows a screen shot from Batstrading.com for Microsoft. During trading hours,
you can watch orders posted and traded live. (Web link on Slide 7.43)
Slide 7.47 Reading Stock Quotes (Web link)
7-13
www: The following ―Work the Web‖ slide includes a hotlink to Bloomberg.com so
students can see the stock quotes online.
Lecture Tip: It often stimulates the class interest to require the students to obtain a
recent Wall Street Journal and have them examine the financial section. Pick out a
familiar stock and have the class perform some of the calculations presented in the
text. Then have the students examine the dividend column for various stocks and point
out the number of non-dividend-paying stocks there are. This could reinforce the text
discussion of how the market values the future dividend stream.
7-14
Slide 7.48 Example: Work the Web (Web link)

www: Click on the Web Surfer icon to go to batstrading.com to look at stock quotes
online.

r = [1.5(1.05) / 18.75] + .05 = 13.4%

Conceptual questions with links to answers.
Slide 7.51 Chapter 7 END
7-15

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Edition Ross Solutions Manual

Introduction 7.2 Key Concepts and Skills

Chapter Section Web Address

ANNOTATED CHAPTER OUTLINE

Slide 7.2 Key Concepts and Skills

Slide 7.3 Chapter Outline

Slide 7.4 Cash Flow to Stockholders

P0 = D1/(1 + R) + D2/(1 + R)2 + D3/(1 + R)3 + …

Shareholders receive returns on common stock in two ways:

Slide 7.5 One-Period Example

Slide 7.7 Two-Period Example

Again, the calculations are straightforward present value calculations.

Price is still $13.33.

Slide 7.8 Three-Period Example

Slide 7.9 Three-Period Example—TI BAII+ CF Worksheet Solution

Slide 7.10 Developing the Model

Slide 7.11 Stock Value = PV of Dividends

FedEx provides an example of a firm beginning to pay a quarterly dividend after a

Slide 7.12 Estimating Dividends: Special Cases

Slide 7.13 Zero Growth

What is the stock worth?

Slide 7.14 Constant Growth Stock

Slide 7.15 Projected Dividends

D1 = D0(1+g); D2 = D1(1+g); in general, Dt = D0(1+g)t.

Note, that this is the same as the future value formula.

Slide 7.16 Dividend Growth Model

Again, emphasize the difference between D0 and D1.

Now multiply both sides by (1+R)/(1+g):

Slide 7.17 DGM: Example 1

Slide 7.19 Stock Price Sensitivity to Dividend Growth, g

Slide 7.20 Stock Price Sensitivity to Required Return, R

Slide 7.21 Example 7.3: Gordon Growth Company I

Slide 7.22 Example 7.3: Gordon Growth Company II

Slide 7.23 Example 7.3: Gordon Growth Company II

Slide 7.24 Constant Growth Model Conditions

Lecture Tip: Students often ask:

―How can g ever be assumed to be constant?‖

The answer lies in the competitive equilibrium model of classical macroeconomics.

―Why do we assume that R > g?‖

Slide 7.25 Nonconstant Growth

Slide 7.26 Nonconstant Growth—Solution

Slide 7.27 Nonconstant + Constant Growth

Slide 7.28 Nonconstant + Constant Growth

Slide 7.29 Nonconstant Growth Followed by Constant Growth

Slide 7.30 Quick Quiz: Part 1

Constant growth: 2(1.03) / (.15 – .03) = $17.17

Slide 7.31 Using the DGM to Find R

Slide 7.32 Finding the Required Return—Example

Slide 7.33 solves the problem using the formula.

Slide 7.35 Valuation with Multiples

Slide 7.36 Valuation with Multiples—Example

Slide 7.37 Table 7.1: Summary of Stock Valuation

Slide 7.38 Features of Common Stock

For more information, see http://www.calpers-governance.org/forumhome.asp.

Slide 7.39 Features of Common Stock—Other Rights

 Sharing proportionately in dividends paid.

Slide 7.40 Dividend Characteristics

Dividends are not tax deductible for the paying firm.

Dividends received by individuals are usually considered ordinary income, while

Slide 7.41 Features of Preferred Stock

Cumulative dividends—current preferred dividend plus all arrearages (unpaid

Slide 7.42 The Stock Markets

Secondary markets—existing shares traded among investors.