Lecture%20Ten%20Cost%20of%20Capital%20From%20Issuing%20Stocks%20or%20Stocks%20and%20Their%20Valuation

1
Lecture TenCost of Capital From Issuing Stocks
or Stocks and Their Valuation

• Determining common stock values
• Efficient markets
• Preferred stock

2
Stock Value PV of Dividends
What is a constant growth stock?
One whose dividends are expected to grow forever
at a constant rate, g.
3
For a constant growth stock,
If g is constant, then
4

0.25
0
Years (t)
5
What happens if g gt ks?

• If kslt g, get negative stock price, which is
  nonsense.
• We cant use model unless (1) ksgt g and (2) g is
  expected to be constant forever. See slide 8-8.

6
Assume beta 1.2, kRF 6, and kM 11. What
is the required rate of return on the firms
stock?
Use the SML to calculate ks
ks kRF (kM - kRF)bFirm 6 (11 - 6)
(1.2) 12. Also, this is the cost of capital
to the firm from issuing common Stk.
7
D0 was 0.25 and g is a constant 6. Find the
expected dividends for the next 3 years, and
their PVs. ks 12.
0
1
2
3
4
g6
0.2809
0.2978
D00.25
0.265
12
0.2366
0.2239
0.2120
8
Whats the stocks market value? D0 0.25, ks
12, g 6.
Constant growth model
9
What is the stocks market value one year from
now, P1?

• D1 will have been paid, so expected dividends are
  D2, D3, D4 and so on. Thus,
• Could also find P1 as follows

10
Find the expected dividend yield, capital gains
yield, and total return during the first year.
11
Rearrange model to rate of return form

Then, ks 0.265/4.42 0.06 0.06 0.06
12. Again, this is the cost of raising
funds from the sale of common stock.
12
What would P0 be if g 0?
The dividend stream would be a perpetuity.
0
1
2
3
12
...
0.25
0.25
0.25

13
If we have supernormal growth of 30 for 3 yrs,
then a long-run constant g 10, what is P0? k
is still 12.

• Can no longer use constant growth model.
• However, growth becomes constant after 3 years.

14
Nonconstant growth followed by constant growth
0
1
2
3
4
ks12
...
g 30
g 30
g 30
g 10
D0 0.25 0.3250 0.4225 0.5493 0.6042
0.2902
0.3368
0.3910
.
0
6042

30
.
P
21


21.5029
3
.
.
12
0
10
-
0

22.52 P0
15
What is the expected dividend yield and capital
gains yield at t 0? At t 4?
16

• During nonconstant growth, D/P and capital gains
  yield are not constant, and capital gains yield
  is less than g.
• After t 3, g constant 10 capital gains
  yield k 12 so D/P 12 - 10 2.

17
Suppose g 0 for t 1 to 3, and then g is a
constant 11. What is P0?

0
1
2
3
4
ks12
...
g 0
g 0
g 0
g 11
0.25 0.25 0.25 0.2775
0.2232
0.1993
.
0
2775
0.1779



P
27.75.
19.7519
3
.
0
01
20.3523
18
What is D/P and capital gains yield at t 0 and
at t 3?
D1
25
0
.


1
23.
.

t 0
P0
35
20
.
CGY

-

12
1
23
10
77.
.
.
t 3 Now have constant growth with g capital
gains yield 11 and D/P 1.
19
If g -6, would anyone buy the stock? If so,
at what price?
Firm still has earnings and still pays dividends,
so P0 gt 0
20
What is the annual D/P and capital gains yield?
Capital gains yield g -6.0, Dividend
yield 12.0 - (-6.0) 18. D/P and cap.
gains yield are constant, with high dividend
yield (18) offsetting negative capital gains
yield.
21
What is market equilibrium?
In equilibrium, stock prices are stable. There is
no general tendency for people to buy versus to
sell. In equilibrium, expected returns
must equal required returns

ks D1/P0 g ks kRF (kM - kRF)b.
22
How is equilibrium established?
D1 P0

If ks g gt ks, then P0 is too low (a
bargain). Buy orders gt sell orders P0 bid up
D1/P0 falls until D1/P0 g ks ks.

23
Why do stock prices change?

1. ki could change ki kRF (kM - kRF
)bi kRF k IP 2. g could change due
to economic or firm situation.
24
Whats the Efficient Market Hypothesis?
EMH Securities are normally in equilibrium and
are fairly priced. One cannot beat the
market except through good luck or better
information.
25
1. Weak-form EMH Cant profit by looking at
past trends. A recent decline is no reason to
think stocks will go up (or down) in the future.
Evidence supports weak-form EMH, but technical
analysis is still used.
26
2. Semistrong-form EMH All publicly available
information is reflected in stock prices, so
doesnt pay to pore over annual reports looking
for undervalued stocks. Largely true, but
superior analysts can still profit by finding and
using new information.
27
3. Strong-form EMH All information, even inside
information, is embedded in stock prices. Not
true--insiders can gain by trading on the basis
of insider information, but thats illegal.
28
Markets are generally efficient because
1. 15,000 or so trained analysts MBAs, CFAs,
Technical PhDs. 2. Work for firms like Merrill,
Morgan, Prudential, which have much
money. 3. Have similar access to data. 4. Thus,
news is reflected in P0 almost instantaneously.
29
Preferred Stock

• Hybrid security.
• Similar to bonds in that preferred stockholders
  receive a fixed dividend which must be paid
  before dividends can be paid on common stock.
• However, unlike interest payments on bonds,
  companies can omit dividend payments on preferred
  stock without fear of pushing the firm into
  bankruptcy.

30
Whats the expected return of preferred stock
with Vps 50 and annual dividend 5?