week 16

Question 1

what is the fundamental theory of valuation

Answer 1

the value of any financial asset equals the present value of all its future cash flows
bond valuation - cash flow (coupon and face value) and discount rate (yield to maturity)
stock valuation - discount rate (required rate of return)

Question 2

what cash flows are associated with a share of common stock

Answer 2

receive cash in dividends or sell shares to another investor
price of stock is PV of expected cash flows

Question 3

what are the difficulties in stock valuation

Answer 3

share of common stock is more difficult to value than a bond
no promised cash flows
cash flows are unknown in advance
life of investment is forever, common stock has no maturity
rate of return required by investors in unobservable

Question 4

how do you calculate stock price today

Answer 4

P0 = sum of Dt / (1+r)^t
assumed firm will not go bankrupt in the future

Question 5

how do you estimate a dividend with zero growth

Answer 5

firm pays constant dividend forever
like preferred stock
price is computed using perpetuity formula

Question 5

how do you estimate a dividend with zero growth

Answer 5

firm pays constant dividend forever
like preferred stock
price is computed using perpetuity formula

Question 6

how do you estimate a dividend with constant dividend growth

Answer 6

firm will increase the dividend by a constant percent every period
like many mature companies

Question 7

how do you estimate a dividend with supernormal growth

Answer 7

dividend growth is not consistent initially, but settles down to constant growth eventually
variation of constant dividend growth

Question 8

what is the PV fpr a dividend with 0 growth

Answer 8

P0 = D/r

Question 9

what is the PV for a dividend with constant growth

Answer 9

P0 = D1 / r-g

Question 10

what is common stock

Answer 10

the stock has no special preference either in paying dividends or in bankruptcy

Question 11

what are features of common stock

Answer 11

voting rights
share of dividends
share of assets in liquidation
right to buy new stock issue if desired

Question 12

what are the voting rights of stock holders

Answer 12

one share = one vote
proxy voting - can transfer right to vote to another party, occurs when minority owners are trying to get a seat on the board
different stock classes have different rights

Question 13

what are the characteristics of dividends

Answer 13

not a liability until declared by board of directors
not a business expense so not tax deductible

Question 14

what is preferred stock

Answer 14

preference over common stock in payment of dividends and bankruptcy

Question 15

what are the features of preferred stock

Answer 15

not a liability
can be deferred indefinitely
most preferred dividends are cumulative and missed preferred dividends have to be paid before common dividends can be paid
generally doesn’t have voting rights

Question 16

what is dividend policy

Answer 16

the decision to pay dividends versus retaining funds to reinvest in the firm
if firm reinvests capital now, it will grow and pay higher dividends in future

Question 17

what factors favour a low payout

Answer 17

taxes - high tax rate on dividends, low tax rate on capital gains
flotation costs - low payouts can decrease amount of capital needing to be raised, lowering floatation costs
dividend restrictions - debt covenants may limit the percentage of income that can be paid out as dividends

Question 18

what factors favour high payout

Answer 18

desire for current income - individuals in low tax brackets, individuals who need income like pensioners
uncertainty resolution - no guarantee in future higher dividends/capital gains will be there, dividends provide return
taxes - used for tax planning

Question 19

why should you pay dividends

Answer 19

reduce agency problems - higher dividend payout means firm has to raise more funds, scrutinised more externally, reduces agency problems
signalling theories - increasing dividends shows positive info about firms future
clientele theories - different investors seek out different stocks based on dividend policy

Question 20

what are the pros of paying dividends

Answer 20

cash dividends underscore good results, provide support to stock price
dividends may attract institutional investors
stock price increases with increased dividends
dividends absorb excess cash and reduce agency costs

Question 21

what are the cons of paying dividends

Answer 21

taxed to recipients - double taxation
reduce internal funding, may forgo projects or need external financing
dividend cuts are hard to make without affecting stock price