chapter 7 Flashcards
what are the 2 expected cash flows from someone who owns a stock?
the dividends the firm pays out
the price of the sold share in the future
according to the law of one price, what does the current price of a stock reflect?
the expected future dividend and stock price
what is the “equity cost of capital”?
the expected return of other investments with equivalent risk
since it it difficult to estimate future dividends of a stock, what do we do to make it more simple?
we simplify the problem by assuming that dividends will grow at a constant rate ‘g’ forever
what are the 2 things a firm can do to maximize their share price?
the firm can increase the level of its dividend payments
they can increase their growth rate
what is the trade off that firms have when trying to maximize their share price?
investing in higher growth may mean using cash that could be used to pay dividends and this could negatively impact future growth
what is the dividend payout rate?
the fraction of earnings that the firm pays as dividends each year
what are the 3 ways a firm can increase its dividends?
increasing their earnings
increasing their dividend payout rate
reducing the number of shares outstanding (increasing EPS)
how can companies reduce the number of shares outstanding?
the firm can buy back existing shares from investors
what are the 2 ways a firm can use their earnings?
to pay dividends
retain and reinvest them
what is the retention rate?
the fraction of current earnings that the firm retains
what does the decision whether to retain more earnings and reduce the current dividend depend on?
depends on the profitability of the firms investment
when will cutting the firms dividend to increase investment raise the stock price?
it will only raise the stock price if the new investments have a positive NPV
what is share repurchase?
when a firm uses excess cash to buy back its own stock
why would the dividend discount model be adjusted?
because that model assumes that firms distribute all cash to shareholders through dividend payments