6.0 Valuation Methods /Cost of Capital Flashcards
Constant Dividend Growth Model (single period)
Stock Valuation
Common Stock
Expected Dividend per share/
Discount Rate - Growth Rate
- Expected Dividend= Last Dividend * (1 + Growth Rate)
Constant Dividend Growth Model (multiple years)
Stock Valuation
Last Dividend + (1 + (Growth percent) t power))/
Discount Rate - Growth
eg. 10 * (1.05)4th power = 12.16/
.12-.05
Variable Dividend (growth then stable) Stock Valuation
2 Stage/3 Steps
12% Return
5% Growth
End of Yr Dividend PV factor PV of Dividend
1 = 5.00 .893 4.47
2 5.00 * 1.05 = 6.00 .797 4.78
3 6.00 * 1.05 = 7.20 .712 5.13
sum 14.38
Step 2
calculate the present value based on steady growth (8%)
a. calculate the next dividend 7.20 * 1.08 = 7.78
b. use standard dividend growth formula
7.78/
.12-.08 = 194.50 x .712 (last pv factor) = 138.48
Step 3
sum the two : 14.38 + 138.48 = 152.86
Preferred Stock Valuation
Preferred Dividend Per Share/
Cost of Capital (Rs)
$12/
.15
Component Cost of Capital - Debt (Existing)
Effective Rate * (1-tax rate)
Component Cost of Capital - Preferred Stock (Existing)
Dividend Yield
Dividend /
Market Price
Component Cost of Capital - Common Stock (Existing)
Dividend Yield
Dividend/
Market Price
Component Cost of Retained Earnings
Normally lower than the cost of Common Stock due to no Issuance costs. (sometimes set equal without flotation costs. )
WACC
Weighted Average Cost of Capital
Is based on the MARKET value, not BOOK
- Calculate each Component Cost
- Calculate each components weight based on Market Value
Component Percent x Component Costs = Value
10% (Debt) 7.41% .741 %
20.91% (Preferred) 11.5% 2.404%
63.64% (Common) 16.00% 10.1824%
1.45% (Retained Earnings) 16.00% .872%
SUM = WACC 14.20%
WACC formula with no preferred stock
Equity/ x Rs Equity x Debt/ x Rd (1 - Tax Rate)
Total Total
Rs = Cost of Equity Rd = Cost of Debt
Effect of Taxes
Capital Gains
Dividends
Interest on Debt
Capital Gains
a. Corporate received Capital Gains=Normal Tax Rate
b. Individual received Capital Gains = 16%
Dividends Received
a. Corp to Corp = 70%-100% tax free
b. Corp to Individual = normal tax rate
Interest on Debt
a. Corp to Individual = Tax Deductible (so Corp prefers debt to Debt
b. Corp to Individual CAPITAL GAINS = INDIVIDUAL investor prefers to CAPITAL GAIN because partially non taxable (This is not debt to dividends but Interest to capital gains
MCC - Marginal Cost of Capital
The cost of NEW capital = the WEIGHTED Average of the NEXT dollar. Not the cost of the specific component
Cost of NEW Debt
Annual Interest Expense/
Net Proceeds
Cost of NEW Preferred Stock
Next Dividend/
Net Proceeds
Cost of NEW Common Stock
Cost of NEW Retained Earnings
Next Dividend/
Net Proceeds + Growth Rate
$8/
$55-3 + 2%
Retained Earnings does not include the $3 Flotation cost
WACC of New Capital
Same as WACC for existing except percentages can be
using the same weight if the company has achieved optimal x each components cost. Or can be adjusted such as using retained earnings first
Long COLLERUP
A long position: the investor hopes to gain with a rise in price in the future
Cash Flow Hedge
A hedge were intent is to protect future cash flows
SHORT HEDGE
person Borrows and then Sells NOW. Then replaces the stock borrowed with lower priced stock later (hopefully)
FAIR VALUE HEDGE
Hedges against the change in Fair Value
NATURAL HEDGE
Does not rely on sophisticated financial instruments
ie financing a piece of equipment over its natural life
Exercise Price (Strike Price) Option Price (Option Premium)
Exercise or Strike Price is the price at which the Option can be acted on
Option Price (Option Premium) the thing that you buy at the specified price for the RIGHT to exercise the option.
Covered Option v
Naked Option
Covered: The SELLER has possession of the underlying
Naked: The SELLER does not yet own the underlying which they may have to perform on
Types of Options
Stock Option: Underlying is a traded stock
Index Option: Underlying is an INDEX. Settlement in Cash delivering underlying is impossible.
LEAPS (Long Term Index Option): up to three years away
Foreign Currency Options: Right to buy a specific currency at a designated EXCHANGE RATE
Call Option
Right to Buy (Call) at a specific price
Intrinsic Value is : Price of Underlying LESS Exercise Price
Out of the Money: Underlying is less than the Exercise Price
In the Money: Underlying exceeds the Exercise Price
At The Money: Underlying equals the Exercise Price
Call Option Gain/Loss Calculation
In The Money
Buyer:
(Underlying over Exercise Price) - Option Price) x Units
Seller
Option Price - (Underlying over Exercise Price) x Units
Out of The Money
Since nothing will be exercised>
Buyer > Option Price paid is the loss
Seller > Option Price received is the gain
Put Option
Right to SELL at a fixed price (Right to Put on the Market)
Intrinsic Value = Exercise Price less the value of underlying
In the Money: Price of underlying is less than exercise
Out of the Money: Price is higher than exercise price
At The Money: Price is at the exercise price
Put Option
Right to SELL at a fixed price (Right to Put on the Market) . A SHORT position.
Intrinsic Value = Exercise Price less the value of underlying
In the Money: Price of underlying is less than exercise
Out of the Money: Price is higher than exercise price
At The Money: Price is at the exercise price
Put Option Gain/Loss Calculation
In The Money:
Buyer
Exercise over Underlying - Option Price x Units
Seller
Option Price - Exercise Price over Underlying x Units
Out of the Money: Buyer Option Price Paid Seller Option Price Received
Put Call Parity Theorem
Value of Call + PV of exercise =
Value of Put + Value of Underlying
PV of exercise is at Rf rate
Restated:
PV of Exercise = Value of Put + Value of Underlying - Value of Call
ie Value of buying a Put + Value of Underlying - Buying a Call = PV of Exercise at risk free rate
Valuing an Option
What happens when underlying changes, exercise changes, Interest rates Change
Volitility, Term
Exercise Price:
INCREASE in exercise of a Call, reduces the value
DECREASE in the exercise of a Put, reduces the value
Price of Underlying:
Call underlying increase = Increase in Call Value
Put Underlying decreases = Increase in Put Value
Interest Rates:
In Inflation, using inflated dollar to pay, thus to pay a Call using inflated dollar so value increase. Put decreases because you are paying the decrease with inflated dollar.
Time to Maturity: Increase Call and Put
Volatility: Increases Call and Put
Forward Contract
A simple hedge: Buyer is locking future delivery at specific price; Buyer is long because he is guarding against higher future. Seller is Short because guarding against lower future.
Different than option because buyer and seller MUST deliver. It is not an option to be exercised
Futures Contract
Rather than specific things to be delivered as in Forward Contract> Undifferentiated Commodities: Currency, Grain
To be delivered in a Month (not a day)
Also, profit or loss is marked daily and settled. Less risk of default
Also Forward delivers actual product. Futures only deliver difference between prices.
Swaps
Interest Rate Swaps:
Firm exchanges payments at one interest rate for another that matches better
Currency Swaps:
Company A need Euros, Company B need USD.
Agree to exchange at a specific rate
Credit Default Swaps: One bank basically insures against to non-pmt to a second bank buy a third party
most swaps are at the money. As interest, exchange rates and credit risks change the swap changes
