week 16 Flashcards
what is the fundamental theory of valuation
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)
what cash flows are associated with a share of common stock
receive cash in dividends or sell shares to another investor
price of stock is PV of expected cash flows
what are the difficulties in stock valuation
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
how do you calculate stock price today
P0 = sum of Dt / (1+r)^t
assumed firm will not go bankrupt in the future
how do you estimate a dividend with zero growth
firm pays constant dividend forever
like preferred stock
price is computed using perpetuity formula
how do you estimate a dividend with zero growth
firm pays constant dividend forever
like preferred stock
price is computed using perpetuity formula
how do you estimate a dividend with constant dividend growth
firm will increase the dividend by a constant percent every period
like many mature companies
how do you estimate a dividend with supernormal growth
dividend growth is not consistent initially, but settles down to constant growth eventually
variation of constant dividend growth
what is the PV fpr a dividend with 0 growth
P0 = D/r
what is the PV for a dividend with constant growth
P0 = D1 / r-g
what is common stock
the stock has no special preference either in paying dividends or in bankruptcy
what are features of common stock
voting rights
share of dividends
share of assets in liquidation
right to buy new stock issue if desired
what are the voting rights of stock holders
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
what are the characteristics of dividends
not a liability until declared by board of directors
not a business expense so not tax deductible
what is preferred stock
preference over common stock in payment of dividends and bankruptcy
what are the features of preferred stock
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
what is dividend policy
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
what factors favour a low payout
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
what factors favour high payout
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
why should you pay dividends
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
what are the pros of paying dividends
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
what are the cons of paying dividends
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
