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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 07
COMMON STOCK VALUATION (Dividend Models)
A company can raise capital from variety of sources. We already covered the loans as a potential source of
capital enhancement. Bonds are a kind of loan that is different form a bank loan.
In this segment, we know that a company may sell its shares to general public (primary market) to gather
funds needed for investment purposes. These shares are significantly different from the Bonds in many
aspects. For example, the salient features of a stock or share are as under:
No promised cash flow for dividend
No date of maturity ­ Investment for ever
Problems in observing rate of return
Common stock, also referred to as common shares, is as the name implies the most usual and commonly
held form of stock in a corporation. The other type of shares that the public can hold in a corporation is
known as preferred stock. Common stock that has been re-purchased by the corporation is known as
treasury stock and is available for a variety of corporate uses.
Common stock typically has voting rights in corporate decision matters, though perhaps different rights
from preferred stock. In order of priority in a liquidation of a corporation, the owners of common stock are
near the last. Dividends paid to the stockholders must be paid to preferred shares before being paid to
common stock shareholders.
COMMON STOCK VALUATION:
The following models are commonly used to valuate the common stock:
DIVIDEND DISCOUNT MODEL:
It is not an easy job to predict or forecast future stock price.
Dividend discount model states that today's price is equal to the present value of all future dividends.
After One year
P0 = Div + P1 / (1 + r)
After 2 years the value of stock is:
=div1/ (1+r) + div2+P2/ (1+r)  2
After 3 years the value of stock is:
=div1/(1+r) + div2/(1+r)2 + div3+P3/(1+r)3
When the time horizon is infinitely far, then we do not consider the final price as it has no present value
today. This mean the PV of stock depends only on future dividends.
DIVIDEND GROWTH MODELS:
Assumed NO GROWTH by the company
Company pays out all as dividend what it earns every year.
It means that NOTHING is reinvested in business.
It means that investors may forecast that future dividends will not increase. Dividends over the
years are at the same level ­ perpetuity.
If the value of stock is the PV of all future dividend then
PV = DIV / r
When company pay out everything as dividend then earnings and dividend will be equal and PV can be
calculated as:
PV = EPS / r
CONSTANT GROWHT MODEL:
Assume that dividends will grow at a constant growth rate. For example 5% per year.
It means that Dividend of Rs. 2 per share at 5% constant growth rate is
Div1 = 2
22
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Corporate Finance ­FIN 622
VU
Div2 = 2 x 1.05 = 2.10
2
Div3 = 2 x (1.05) = 2.205
Fitting these into formula:
= D1/1+r + D1(1+g)/(1+r) + D1(1+g) /(1+r) ....
2
2
3
2
3
= 2/1.12 + 2.10/ (1.12) + 2.205/ (1.12) = 1.79 + 1.67 + 1.57 + ....
Although the number of terms is infinite, the PV of dividend is proportionately smaller than the preceding
term and this will continue as long as growth rate is less than the discount rate.
Because the far distant dividends will be close to zero, the sum of all of these terms is finite despite the fact
that an infinite number of dividends will be paid.
So we can write equation as:
P0 = D1 x (1+g) / (r ­ g)
This is known as Constant-growth Dividend Discount Model or Gordon Growth Model.
For example:
2 x 1.05 / .12 - .05 = 30.00
Gordon model is valid as long as g < r
Example:
Dividend paid = Rs. 2.30
Growth rate = 5%
Required return = 13%
What will be the value of stock after five years?
5
D5 = 2.30 X (1.05) = 2.935
P5 = 2.935 x 1.05 / (.13 -.05) = 38.53
Example:
The next dividend of a company will be Rs 4 per share. Investors demand 16 percent return on share
having same risk level as of this company. The dividend growth is 6% per year. Calculate the value of this
company's stock today and in four years using dividend growth model.
Solution:
Next dividend has already been given:
Po = D1 / (r ­g)
Po = 4 / (.16 -.06)
Po = 40
Price in 4 years:
D4 = 4 x (1.06) = 4.764
3
P4 = 4.764 x 1.06 / (0.16 -0.06) = 50.50
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk