AHIP Business Finance Exam 2 Notes (Chapter 7) 2023

NASDAQ

Computer-based quotation system Multiple market makers Electronic Communications Networks Large portion of technology stocks

Constant growth model conditions

1. Dividend expected to grow at g forever 2. Stock price expected to grow at g forever 3. Expected dividend yield is constant 4. Expected capital gains yield is constant and equal to g 5. Expected total return, R, must be > g 6. Expected total return (R): = expected dividend yield (DY) + expected growth rate (g) = dividend yield + g

Requied return can only come from 2 components:

1. Dividend yield 2. Capital gains yield

How many assumed seats to fill/being elected into?

3

Dividends received by corporations have a minimum ________ exclusion from taxable income.

70%

Is it possible for a company to pay dividends when it has a negative net income for the year? Could this happen for longer periods?

For a particular year, this can (and often does) happen. Going back to the cash flow identity, the dividend payments depend on operating cash flow, capital spending, the change in net working capital, and the cash flow to creditors. The firm could have positive operating cash flow with negative earnings, sell fixed assets, reduce net working capital, or raise cash from creditors in order to pay dividends. While this is possible in the short term, as a practical matter over the longer term, the company would probably need to have a positive net income (at least on average) in order to maintain a dividend.

Cumulative voting

If 4 people have 250,001 shares, 250,000, 250,000, and 249,999, only those top three would have ownership Have to break any four way tie

Straight voting

If there are 1,000,000 available shares, you would need 500,001 to win (Half plus one)

Dividend yield

D1 / P0

D0

Dividend JUST PAID

Supernormal growth

Dividend growth is not consistent initially, but settles down to constant growth eventually

Perpetuity

Dividends expected at regular intervals forever P0 = D / R

ECNs

Electronic Communications Networks Provide direct trading among investors

D1 to Dt

Expected dividends

Constant dividend growth

Firm will increase the divided by a constant percent every period One whose dividends are expected to grow forever at a constant rate, g.

Constant dividend/Zero growth

Firm will pay a constant dividend forever Dividends expected at regular intervals forever (perpetuity) Like preferred stock Price is computed using the perpetuity formula

In the context of the dividend growth model, is it true that the growth rate in dividends and the growth rate in the price of the stock are identical?

The dividend growth model makes the implicit assumption that the stock price will grow at the same constant rate as the dividend. What this means is that if the cash flows on an investment grow at a constant rate through time, the value of that investment grows at the same rate as the cash flows.

Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typically larger?

The two components are the dividend yield and the capital gains yield. For most companies, the capital gains yield is larger. This is easy to see for companies that pay no dividends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less.

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.

Preferred stock is like a hybrid between...

a stock and a bond.

Dividends for preferred stock can be deferred...

indefinitely.

Dividends are taxed as ______________________ for individuals.

ordinary income

In addition to common stock, some corporations have issued...

preferred stock.

The price of the stock being sold is really just the...

present value of all expected future dividends Stock value = PV of dividends

As with bonds, the price of the stock is the...

present value of these expected cash flows Dividends --> cash income Selling --> capital gains

Stocks that don't pay dividends (or have erratic dividend growth rates) can be valued using the...

price-earnings (PE) ratio and/or the price-sales ratio

Most voting is done by...

proxy.

Required return equation

r = (D1 / P0) + g

Boards are often...

staggered, or "classified"

Dividends are not a liability of the firm until declared by...

the Board of Directors.

As the owner of shares of common stock in a corporation, you have various rights, including:

the right to vote to elect corporate directors.

The two biggest stock markets in the United States

NYSE NASDAQ

Are dividends of preferred stock a liability of a firm?

No.

Are dividends tax deductible for a firm?

No.

Does preferred stock generally carry voting rights?

No.

Are companies required to pay out dividends?

No. Dividends are not an obligation for a company...whether a company issues dividends or not can change at any time

Zero growth example: Suppose stock is expected to pay a $2.00 dividend every year and the required return is 10%. What is the price?

P0 = $2/.10 = $20

Suppose a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Which do you think will have a higher price, a share of the preferred or a share of the common?

The common stock probably has a higher price because the dividend can grow, whereas it is fixed on the preferred. However, the preferred is less risky because of the dividend and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances.

3 special cases of estimating dividends

1. Constant dividend/Zero growth 2. Constant growth 3. Supernormal growth

Voting in corporate elections can be either:

1. Cumulative 2. Straight

Rights of common stock

- Share proportionally in declared dividends - Share proportionally in remaining assets during liquidation - Preemptive right

Classes of stock

1. Founders' shares 2. Class A and Class B shares

Types of stock markets

1. Primary: new-issue market (the company gets the money) 2. Secondary: existing shares traded among investors

If you own a share of stock, what are the two ways you can receive cash?

1. The company pays dividends 2. You sell shares, either to another investor in the market or back to the company

In the constant dividend growth model, what is the highest reasonable growth rate for a stock's dividend?

A reasonable limit for the growth rate is the growth rate of the economy, which in the U.S. has historically been about 3 to 3.5 percent (after accounting for inflation). As we will see in a later chapter, inflation has historically averaged about 3 percent, so 6 to 6.5 percent (before accounting for inflation) would be a reasonable limit.

Operational goal of NYSE

Attract order flow

Broker

Brings buyers and sellers together Doesn't actually own any inventory Like a real estate agent/broker

In the chapter, we mentioned that many companies have been under pressure to declassify their boards of directors. Why would investors want a board to be declassified? What are the advantages of a classified board?

In a declassified board, every board seat is up for election every year. This structure allows investors to vote out a director (and even the entire board) much more quickly if investors are dissatisfied. However, this structure also makes it more difficult to fight off a hostile takeover bid. In contrast, a classified board can more effectively negotiate on behalf of stockholders, perhaps securing better terms in a deal. Classified boards are also important for institutional memory. If an entire board were voted out in a single year, there would be no board members available to evaluate the company's direction with regards to previous decisions.

Referring to the previous questions, 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. This question is examined in depth in a later chapter.

A substantial percentage of the companies listed on the NYSE and the NASDAQ don't pay dividends, but investors are nonetheless willing to buy shares in them. How is this possible given your answer to the previous question?

Investors believe the company will eventually start paying dividends (or be sold to another company).

Some companies, such as Google, have created classes of stock with little or no voting rights at all. Why would investors buy such stock?

Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay less for such shares than they would otherwise.

Is it unfair or unethical for corporations to create classes of stock with unequal voting rights?

It wouldn't seem to be. Investors who don't like the voting features of a particular class of stock are under no obligation to buy it.

3 levels of information in the NASDAQ

Level 1: median quotes, registered representatives Level 2: view quotes, brokers and dealers Level 3: view and update quotes, dealers only

Dealer

Maintains an inventory Ready to buy or sell at any time Like a used car dealer

New York Stock Exchange

Members historically by a trading license ("own a seat") Designated market makers Floor brokers

__________________________ have to be paid before common dividends can be paid.

Missed preferred dividends

Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

Preemptive right

Right of first refusal to buy new stock issue to maintain proportional ownership if desired

Who elects directors?

Stockholders

Under what two assumptions can we use the dividend growth model presented in the chapter to determine the value of a share of stock? Comment on the reasonableness of these assumptions.

The general method for valuing a share of stock is to find the present value of all expected future dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assumption might be a company that is expected to cease operations and dissolve itself some finite number of years from now. The stock of such a company would be valued by the methods of this chapter by applying the general method of valuation. A violation of the second assumption might be a start-up firm that isn't currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method of this chapter.

What are the difficulties in using the PE ratio to value stock?

The major difficulty in using price ratio analysis is determining the correct benchmark PE ratio. In a previous chapter, we showed how the sustainable growth rate is determined, and in a future chapter we will discuss the required return. Although not exact measures, the growth rate and required return have a solid economic basis. With the PE ratio, like any other ratio, it is difficult to determine what the ratio should be. Since a small difference in the PE ratio can have a significant effect on the calculated stock price, it is easy to arrive at an incorrect valuation.

Nonconstant growth

We have to find the PV of ALL expected future dividends

If the required return (R) goes down, the stock price...

also goes down

If the dividend price (g) grows, the stock price...

also grows.

Preferred stockholders must...

be paid first, before common stockholders can receive anything.

Proxy battles...

break out when competing sides try to gain enough votes to have their candidates for the board elected. Someone seeks after a bunch of investors' proxy votes so they can take control of the project

Most preferred dividends are...

cumulative.

The price is based on looking at the following year's...

dividend.

Preferred stock must be paid before...

dividends can be paid out to common stockholders

Preferred stock has a...

fixed dividend.

The cash flows from owning a share of stock come in the form of...

future dividends.

In P0 = D1 / (r-g), ____ cannot be bigger than ____ .

g; r