Finance Chapter 8

Valuing Preferred Stock: What are the Cash Flows?

Dividend payments

Valuing Preferred Stock: How do we Know How Much they will Be?

Fixed - stated either as a dollar amount or as a percent of par

Valuing Common Stock: What are the Cash Flows?

Dividend payment

Valuing Preferred Stock: How Long will the Dividend Occur?

Forever - preferred stock does not have a specific maturity date

Specialist (market maker)

A NYSE member acting as a dealer in a small number of securities on the exchange floor

Constant Growth Model

A dividend for a security that always grows at a steady rate

Proxy

A grant of authority by a shareholder allowing another individual to vote his or her shares

Valuing Preferred Stock: Thus, What are we Valuing?

A perpetuity

Straight Voting

A procedure in which a shareholder may cast all votes for each member of the board of directors

Cumulative Voting

A procedure in which a shareholder may cast all votes for one member of the board of directors

Dividend Yield

A stock's expected cash dividend divided by its current price

Broker

An agent who arranges security transactions among investors

Dealer

An agent who buys and sells securities from inventory

Common Stock Characteristics

Does not have a maturity date; it exists as long as the firm does Does not have a fixed dividend; must be declared each quarter Generally has voting rights Provides limited liability to shareholders Has a claim on the firm's income and assets that comes after debtholders and preferred stockholders (residual claimant)

Valuing Common Stock: How Long Will the Dividends Occur?

Forever, since common stock also does not have a specific maturity/ending date

Preferred Stock Characteristics

Has no fixed maturity date The nonpayment of dividends does not cause bankruptcy Dividends are not a tax deductible expense for the firm Dividends are fixed/limited in amount

Some companies, such as Reader's Digest, have created classes of stock with 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 a little less for such shares than they would otherwise.

Dividend Growth Model

Is a model that determines the current price of a stock as its dividend next period divided by the discount rate less the dividend growth rate

Common Stock

Is stock that has no special preference either in receiving dividends or in bankruptcy Equity without priority for dividends or in bankruptcy

Common Stock Components

Par Value or Common Stock at Par Additional Paid-In Capital or Common Stock In Excess of Par Retained Earnings

Dividends

Payments by a corporation to shareholders, made in either cash or stock

Valuing Common Stock: Thus what are we Valuing?

Potentially, an uneven and difficult to predict infinite stream of cash flows

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.

Preferred Stock

Stock with dividend priority over common stock, normally with a fixed dividend rate, sometimes without voting rights Is considered a "hybrid" security that has characteristics of both common stocks and bonds.

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

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

The dividend growth model presented in the text is only valid (a) if dividends are expected to occur forever, and (b) if a constant growth rate of dividends occurs forever.

Primary Market

The market in which new securities are orginally sold to investors New York Stock Exchange NASDAQ

Secondary Market

The market in which previously issued securities are traded among investors

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

Valuing Common Stock: How do we Know how Much they will Be?

They are NOT fixed, nor known with certainty at any given point in time. Investors hope/want the dividends to increase