Unit 6: Valuation Methods & Cost Of Capital Flashcards
Dividend growth model
Expected dividend per share / (Discount rate - Dividend growth rate)
= the $ value of a common stock
Expected dividend
Last annual dividend paid x (1+ growth rate) ^ t
Two stage dividend discount model
- Sum of the PV of dividends in the high growth period
- Calculate the PV of the stock in steady growth period discounting back to year 1
- Sum total
For common stock
Preferred stock valuation
Dividend per share / Cost of capital
When preferred stock pays a fixed dividend ex. 12$
Rate of return on investment
Return on investment / Amount invested
Marginal cost of capital
(Definition)
The weighted -average cost to the firm of the next dollar of new capital raised after existing internal sources are exhausted.
Cost of new capital
(Formula)
= Annual interest / Net issue proceeds
Cost of new preferred stock
(Formula)
Next dividend / Net issue proceeds
*This includes flotation costs
Cost of new common stock
(Formula)
(Next dividend / Net issue proceeds) + Dividend growth rate
*Mature firms rarely issue new stock
Derivative instrument
an investment transaction in which the parties’ gain or loss is derived from some other economic event, for example, the price of a given stock, a foreign currency exchange rate, or the price of a certain commodity
Hedging
the process of using offsetting commitments to minimize or avoid the impact of adverse price movements
Long Position
A person who would like to sell an asset in the future.
They benefit from a rise in value of the asset
Short Hedge
Owner of a long position can purchase an instrument whose value will rise if the asset’s value falls
Short Position
Someone who wants to buy an asset in the future.
They benefit from a fall in value of the asset.
Long Hedge
Someone in a short position obtains an instrument whose value will rise if the asset’s value rises.
Natural Hedge
Normal operations that mitigate risk.
Ex. financing long term asset over same period as the life of the equipment.
Forward Contract
Two parties agree that at a set future date one will perform and the other will pay a set price. Neither has the option of non performance.
Ex. wholesaler agrees to buy clothes from a retailer on x/x for $$
Futures Contract
A commitment to buy or sell an asset at a fixed price during a specific future month. Unlike forward contracts, the counterparty is unknown.
Future contracts are traded on _______
Futures Exchanges
In futures exchanges, the _____________ matches sellers who will deliver during a given month with buyers who are seeking delivery during the same month.
Clearing House
Do futures contracts take delivery?
Not necessarily. Parties can exchange the difference between the market price and contracted price.
Option
Party purchases the right to demand that the counterparty (seller) perform some action on or before a specified date.
The buyer can exercise or not.
Exercise Point (Strike Price)
Price at which the owner of a option can purchase or sell the asset underlying the option contract. The set price for the option.
Option Price (Option Premium)
the amount the buyer pays to the seller to acquire an option
Naked (uncovered) Option
a speculative instrument, the writer does not hold the underlying asset, they may have to acquire it in the future to satisfy their obligations
Call Option
Gives the buyer the right to purchase the underlying asset at a fixed price. A long position for the buyer.
Put Option
Gives the buyer the right to sell the underlying asset at a fixed price. A short position for the buyer.
Risk Free Put-Call Parity
(formula)
PV of exercise price = Value of put + Value of underlying - Value of call
Buying a put, buying the underlying asset, and selling a call, provides the same return as investing the PV of the exercise price at the risk free rate.
Models for Valuing Options
- Black-Scholes formula
- Binomial Method
Interest Rate Swap
agreements to exchange interest payments based on one interest structure for payments based on another structure.
Currency Swap
agreements to exchange cash flows denominated in one currency for cash flows denominated in another
