In chapter 8, we turn to the other major source of fi nancing for corporations: common and preferred stock. After studying this chapter you will be able to understand: How stock prices depend on future dividends and dividend growth, the different ways corporate directors are elected to office, how the stock markets work. | Chapter Outline Chapter 8 Stock Valuation Chapter Organization Common Stock Valuation Common Stock Features Preferred Stock Features Stock Market Reporting Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. Common Stock Cash Flows and the Fundamental Theory of Valuation In 1938, John Burr Williams postulated what has become the fundamental theory of valuation: The value today of any financial asset equals the present value of all of its future cash flows. For common stocks, this implies the following: D1 P1 D2 P2 P0 = + and P1 = + (1 + R)1 (1 + R)1 (1 + R)1 (1 + R)1 substituting for P1 gives D1 D2 P2 P0 = + + . Continuing to substitute, we obtain (1 + R)1 (1 + R)2 (1 + R)2 D1 D2 D3 D4 P0 = + + + + (1 + R)1 (1 + R)2 (1 + R)3 (1 + R)4 Common Stock Valuation: The Zero Growth Case According to the fundamental theory of value, the value of a financial asset at any point in time equals the present value of all future dividends. If all future dividends are the same, the present value of the dividend stream constitutes a perpetuity. The present value of a perpetuity is equal to C/r or, in this case, D1/R. Question: Cooper, Inc. common stock currently pays a $ dividend, which is expected to remain constant forever. If the required return on Cooper stock is 10%, what should the stock sell for today? Answer: P0 = $1/.10 = $10. Question: Given no change in the variables, what will the stock be worth in one year? Common Stock Valuation: The Zero Growth Case (concluded) Answer: One year from now, the value of the stock, P1, must be equal to the present value of all remaining future dividends. Since the dividend is constant, D2 = D1 , and P1 = D2/R = $1/.10 = $10. In other words, in the absence of any changes in expected cash flows (and given a constant discount rate), the price of a no-growth stock will never change. Put another way, there is no reason to expect | Chapter Outline Chapter 8 Stock Valuation Chapter Organization Common Stock Valuation Common Stock Features Preferred Stock Features Stock Market Reporting Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE Irwin/McGraw-Hill copyright © 2002 McGraw-Hill Ryerson, Ltd. Common Stock Cash Flows and the Fundamental Theory of Valuation In 1938, John Burr Williams postulated what has become the fundamental theory of valuation: The value today of any financial asset equals the present value of all of its future cash flows. For common stocks, this implies the following: D1 P1 D2 P2 P0 = + and P1 = + (1 + R)1 (1 + R)1 (1 + R)1 (1 + R)1 substituting for P1 gives D1 D2 P2 P0 = + + . Continuing to substitute, we obtain (1 + R)1 (1 + R)2 (1 + R)2 D1 D2 D3 D4 P0 = + + + + (1 + R)1 (1 + R)2 (1 + R)3 (1 + R)4 Common Stock Valuation: The Zero Growth Case According to the fundamental theory of value, the value of a financial asset at any point in time .
