FM Lecture 4

Metallica Bearings, Inc., is a young start-up company. No dividends will be paid on the stock over the next nine years, because the firm needs to plow back its earnings to fuel growth. The company will then pay a dividend of $15 per share 10 years from today and will increase the dividend by 5 percent per year thereafter. If the required return on this stock is 14 percent, what is the current share price? ***

D_11= 15(1.05) P_10= 15.75/(.14-.05)=175 P_0= (175+15)/(1.14^10)

Yang Corp. is growing quickly. Dividends are expected to grow at a rate of 25 percent for the next three years, with the growth rate falling off to a constant 6 percent thereafter. If the required return is 13 percent and the company just paid a $2.50 dividend, what is the current share price?

D_1=2.5(1.25)=3.125 D_2=3.125(1.25)=3.906 D_3=3.906(1.25)=4.883 D_4=4.883(1.06)=5.176 P_3=5.176/(.13-.06) = 73.943 P_0=3.125/1.13 + 3.906/(1.13^2) + (4.883+73.943)/(1.13^3)

What are the three factors that determine a company's price-earnings ratio?

A stock's Price Earning (PE) ratio is likely a function of three factors: 1. Growth opportunities. Companies with significant growth opportunities are likely to have high PE ratios. 2. Risk. Low risk stocks are likely to have high PE ratios. 3. Accounting practices. Accounting practices can have an impact on the earning of a company

Market spread =

Best ask - Best bid

dividend has 0 growth rate (P_0)=

D/R

Under what circumstances might a company choose not to pay dividends?

In general, companies that need the cash will often forgo dividends since dividends are a cash expense. Young, growing companies with profitable investment opportunities are one example; another example is a company in financial distress.

A stock's PE ratio is the ratio of a stock's price (P) to its earnings per share (EPS). (Write in formula form)

PE = P/EPS

Anton, Inc., just paid a dividend of $1.95 per share on its stock. The dividends are expected to grow at a constant rate of 4.1 percent per year, indefinitely. If investors required a return of 10.2 percent on this stock, what is the current price? What will be the price in three years? ***

P_0 = (1.95x1.041)/(.102-.041) P_3 = [1.95(1.041)^4]/(.102-.041)

Alpha Corporation is expected to pay the following dividends over the next four years: $3, $10, $15 and $3.08 respectively. Afterwards, the company pledges to maintain a constant 5 percent growth rate on dividends, forever. If the required return on the stocks is 11 percent, what is the current share price?

P_4 = (3.08x1.05)/(.11-.05)=53.9 P_0= 3/1.11 + 10/(1.11^2) + 15/(1.11^3) + (3.08+53.9)/(1.11^4)

Supposed a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Do you think the price will be the same? Explain?

The price of the common stock will most likely be different from the price of the preferred stock as both stocks have different characteristics. In a common stock, the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference.

Why does the value of a share of stock depend on dividends?

The value of any investment depends on its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the dividends.

common stock

refers to equity without priority for dividends or bankruptcy