COMMON STOCK

Common
COMMON STOCKS

Securities that represents the ownership in the company

stock is a security issued by a company to raise equity capital. It is one of the major sources of long-term (permanent) capital. Funds provided by common equity are used to finance major portion of the firm's fixed assets such as land and building, plant and machinery, vehicle, etc. Common stock represents ownership of the company. Common stockholders of a company are its real owners. Their liability, however, is limited to the amount of their investment. Common stock certificates are legal documents that evidence ownership of the holders in a company. Common stockholders have residual claim on income and asset. Common stock dividend is paid after payment of interest to the creditors, tax to the government, preferred dividend to the preferred stockholders. Similarly, in the event of liquidation, common stockholders have a residual claim on the assets of the company after the claim of all creditors and preferred stockholders are settled in full. Common stock does not have a maturity date. Shareholders, however, can sell their stocks in the secondary market. Hence, the company which needs fund for indefinite period issues shares of common stock. Common stocks have some specific features. The corporate charter of a company specifies the number of authorized shares of common stock. The firm cannot sell more shares than the charter authorizes without obtaining approval from its owners through a shareholder vote or without amending its charter. As it is difficult to amend the charter to authorize the issue of additional shares, firm generally issues shares less than the authorized shares. When shares of common stock are sold, they become issued shares. All or some portion of these share are purchased and actually held by the investors, which are called outstanding shares. If firm repurchases any of its outstanding shares, these shares are recorded as treasury stock and shown as a deduction from shareholders equity in the firms balance sheet.

AUTHORIZED SHARE

The number of shares of common stock that a firm's corporate charter allows to issue
ISSUED SHARE

The number of shares of common stock that have been offered by the company to sell

TREASURY STOCK

The number of outstanding stock that have been purchased and held by the firm

FeaturesofCommonStock
Par Value
PAR VALUE

A recorded value of a share of common stock in the firm's corporate charter

Par value is stated price in common stock certificates. The corporate charter specifies the par value of a share of common stock. In Nepal, Companies Act 2063 (2006 A.D.) has given flexibility to set a par value. A company can set a par value of Rs 50 each or any other higher amount divisible by the figure ten as provided in the memorandum of association and articles of association. A company should not issue common stock at a price less than par value, because any discount from par value is considered to be a contingent liability of the owners to the creditors of the company. In the event of liquidation,

the shareholders would be legally liable to the creditors for any discount from par value. But in Nepal, Companies Act 2063 has prohibited issuing shares at discount. Maturity Common stock has no maturity date. It exists as long as the firm does. Therefore, capital raised from common stocks is also called fixed or permanent capital. Claim on Income and Assets Common stockholders have residual claim on income. Common stockholders are paid after satisfying claims of creditors, bondholders and preferred stockholders. Residual income can be distributed to common shareholders directly in the form of dividends or retained and reinvested by the firm. Just as common stock has a residual claim on income, it also has residual claim on assets in case of liquidation. When a firm is declared bankrupt, its assets are sold, and at first, the proceeds are distributed to employees, to the government, to secured creditors, to unsecured creditors, to preferred stockholders and finally to common stockholders. This residual claim on income and asset increases the risk to the common stockholders. Voting Rights
PROXY

A legal document that gives the person the authority to act for another

Generally, each share of common stock entitles the holder to cast one vote in the election of directors and in other major decisions. Common stockholders can attend at the annual general meeting and cast vote in person or by means of a proxy. A proxy is a legal document giving one person the authority to represent on behalf of others.

Preemptive Rights
PREEMPTIVE RIGHT

A provision that gives the existing shareholders right to purchase new share at subscribed price on pro-rata basis

Common stockholders also have preemptive right. The preemptive right gives the existing shareholders right to purchase any new shares issued by the company at subscribed price on pro-rata basis. Preemptive rights allow common stockholders to maintain their proportionate ownership and control in the company.

Limited Liability Although the common shareholders are the actual owner of the company and have residual claim on all assets, their liability in case of the liquidation/ bankruptcy is limited to the amount of their investment. But shareholders' liability will not exceed the par value. Classified Common Stock Most firms have only one type of common stock. However, small, new companies seeking funds from outsides sources, frequently issue more than one class of common stock to retain control over the management or for other special purpose. For example, common stock might be classified according to voting power and to the claim on income. Generally classified common stock is given a special

designation, such as class A, class B, and so forth. Class A common stock of a company may have inferior voting privileges but may be entitled to a prior claim to dividend, whereas class B common stock may have superior voting right but a lower claim to dividends.

VALUATION CONCEPTS
BOOK VALUE

Net worth of the firm that includes share capital, share premium and retained earnings

TABLE 6.1

Balance sheet of ABC Company As on 31st Dec 2004

Book value. Book value is an accounting concept. The firms book value of equity includes common stock, share premium (paid in capital) and retained earning. It represents owners' contribution to the firm, hence is known as the net worth of a firm. Book value per share is simply the amount per share of common stock to be received if all of the firms assets are sold for their exact book value and all liabilities (including preference stock) are paid. Book value per share is computed by dividing total book value by number of shares outstanding. Table 6.1 shows that book value of ABC Company on 31st December, 2004 is Rs 500,000 (common stock Rs 100,000 paid in capital Rs 200,000 and retained earning Rs 200,000) and book value per share is Rs 50 (i.e. Rs 500,000/10,000 shares).
Liabilities and capital Current liabilities Long term debt Common stock (10,000 shares) Paid in capital (share premium) Retained earning Total Amount (Rs ) 100,000 400,000 100,000 200,000 200,000 1,000,000 Assets Current assets Fixed assets Amount (Rs ) 400,000 600,000

Total

1,000,000

LIQUIDATION VALUE

Company could realize if it sells its assets after having terminated its business and paying all creditors

Liquidation value. Liquidation value is the amount that a company could realize if it sells its assets after having terminated its business and paying all creditors. Liquidation value does not include the value of intangible and fictitious assets since the operations of the company are assumed to cease. This value is different from going concern value. Going concern value is the amount at which firm can be sold for as a continuing operating business rather than selling all the assets separately. This measure is more realistic than book value but still fails to consider the earning power of the firms assets. Intrinsic value. Intrinsic value of a security is theoretical value or fair value. It is based on future cash flows, future prospects, future state of the economy and other factors that affect the valuation of the security or asset. Intrinsic value of a security is its economic value. In an efficient market there is no significant difference between market value and intrinsic value of the security. Intrinsic value is calculated as the present value of the expected cash flow stream discounted at the investors appropriate required rate of return. Market value. Market value of a security (common stock) is the current (actual) price at which the stock is being traded in the market.

INTRINSIC VALUE

Present value of expected future cash flows discounted at appropriate required rate of return

MARKET VALUE

The price of an asset at which the asset is traded in the market

Companys future growth, earnings, earning power, level of risk etc. are reflected in market price of the security. Therefore, common stocks price fluctuates widely. Market value per share is expected to be higher than the book value and liquidation value per share for profitable, and growing firms.

ZeroGrowth
ZERO GROWTH MODEL

An approach to dividend valuation model that assumes amount of dividend per share remains constant forever

If a firms future dividend payments are expected to remain constant forever, zero growth model is used to compute value of the common stock. This is the simplest approach to dividend valuation and is similar to valuation of preferred stock. Zero growth stock's expected dividend per share always remains constant i.e. D0 = D1 = D2 = Dn. The value of zero growth stock can be calculated as
P0 = = (6.2)

For example, assume that the dividends per share of Janakpur Tile are expected to be Rs 30 per year indefinitely. Investor requires a 15 percent rate of return. What should be the intrinsic value of the stock?
Intrinsic value of the stock P0 = = = Rs 200 The intrinsic value is Rs 200.

ConstantorNormalGrowth
CONSTANT GROWTH MODEL

A widely used dividend valuation approach that assumes that dividends will grow at a constant rate is less than required rate of return

The most commonly used dividend discount model, the constant growth model, assumes that dividend will grow forever at a constant rate (g) and it is less than required return, ks. This model is also known as Gordon Model. If a firms future dividend payments per share are expected to grow at a constant rate, gc, per period forever then the dividend at any future time period t can be forecast as follows:
Dt = D0(1+g)t

Where D0 is the dividend per share of the base year. The intrinsic value of the stock which is equal to the present value of its expected future dividends can be computed as
P0 = + + ...
Where, D1 P0 ks g = expected dividend per share at the end of year 1 = price of stock today = investors' required rate of return = growth rate

(6.3)

To illustrate the constant growth dividend valuation model, assume Himalya Electronic Companys common stock paid a dividend Rs 10 per-share last year, which is expected to grow at a constant rate of 5 percent forever. What is the value of the stock to an investor who requires a 12 percent rate of return?
Value of constant growth stock P0 = = = = Rs 150 The value of Himalaya Electronics' common stock should be Rs 150.

Note that if companys dividend payout ratio and return on equity are constant, Companys growth rate, g, will be constant. * In this condition, firms earning and dividends will grow at a constant rate:
g = b ROE =br
Where b is retention ratio, i.e. 1-dividend payout ratio. And r is reinvestment rate or Return on Equity (ROE)

NonConstantorSuperNormalGrowth
NON-CONSTANT GROWTH MODEL

A dividend valuation approach that allows for a change in the dividend growth rate

The dividend of a company may not grow at a constant rate indefinitely. Typically, many firms experience a period of rapid growth above normal rate as they exploit new technologies, new markets etc. This super growth, however, does not remain constant for a long period. Afterwards earnings and dividends grow at a normal rate comparable to the overall average rate of growth in the economy. There is no single model that can be applied, when non-constant growth is anticipated. Thus value of supernormal/non-constant growth stock is equal to the present value of expected yearly dividends during the period of non-constant growth plus the present value of the expected stock price at the end of the non-constant growth period. Here we notice that after super normal growth (non-constant growth) for n periods, the stock will grow at a constant rate, g C. 'n' is often called the terminal date, or horizon date. Similarly, value of stock at horizon date is called horizon or terminal value. The process of computing value of a non-constant growth stock can be summarized as: 1. 2. 3. 4. 5.
P0 =

Find DPS for the period of non-constant growth i.e. D1, D2 . . . Dn. Find the value of the stock at the end of non-constant growth period or horizon value (Pn). Find PV of the dividends during the period of non-constant growth. Find PV of the horizon/terminal value of stock (Pn). Add these two components to find the intrinsic value of the stock (P0).
+ + ... + + (6.4)

PV of dividends during non-constant/Super growth period

Where,

PV of the expected stock price at the end of non-constant growth period or horizon value, Pn

If historical dividend per share is given growth rate can be computed using following equation: DPSt = DPSt - n (1 + g)n g= DPSt = Dividend per share at time t DPSt - n = Dividend per share at time t - n

or, Where

= number of years

Horizon value, Pn =

To illustrate the non-constant growth dividend valuation model, assume XYZ Company paid dividend Rs 20 per share last year. Its dividends are expected to grow at 10 percent for three years and then at a rate of 5 percent indefinitely. The investors required return is 12 percent. What is the price of the share today?
0 1
g =10% 10%

10%

g=5%

5%

D1 = 22 19.64 19.29 18.95 57.88 12% 12%

D2=24.2

D3=26.62

D4=27.95

12% PV of dividends during the non-constant growth P3 = = = 399.3

(Horizon value)

284.2 PV of horizon value 342.08

12%

PV of dividends during the non-constant growth plus PV of horizon value of stock (PN)

Explanation of calculations: Step 1: Compute the dividends for each year during non-constant growth period Dt = D0 (1 + g)t D1 = Rs 20 (1 + 0.10) = Rs 22 D2 = Rs 20 (1.10)2 = Rs 24.2 or 22 (1 + 0.10) = Rs 24.2 D3 = Rs 20 (1.10)3 = Rs 26.62 or 24.2 (1 + 0.10) = Rs 26.62 Step 2: Compute value of the stock at the end of non-constant growth period or at the beginning of the constant growth or horizon value. Here non-constant growth ends in three years, so compute P3 P3 = = = Rs 399.3 Step 3: Compute P.V. of dividends that are received during nonconstant growth period PV of dividends = + + = + + = Rs 19.64 + Rs 19.29 + Rs 18.95 = Rs 57.88 Step 4: Compute PV of P3 or horizon value PV of P3 = = = Rs 284.21 Step 5: Add PV of dividends and PV of horizon value to compute intrinsic value of stock. Intrinsic value of stock = PV of dividends + PV of horizon value = Rs 57.88 + Rs 284.21

= Rs 342.09 Alternatively, Year 1 2 3 Dt(Rs ) 20 (1.10) = 22 22 (1.10) = 24.2 24.2 (1.10) = 26.62 PV factor @ 12% 0.8929 0.7972 0.7118 PV of dividends = 284.21 = 342.09 PV(Rs ) 19.64 19.29 18.95 57.88

Add PV of P3 = PVIFk, 3 = 0.7118 Value of stock at present

Although life of common stock is infinite, the holding period of an investor may be finite. The holding period may be single and multiple. During this holding period, the investor gets cash inflows in the form of dividend and expected future price of stock. Hence, equation for common stock valuation is to be slightly modified.

SinglePeriodValuation
Let us assume that investor plans to buy a common stock and holds it for one year (or period). At the end of the given period, the investor expects to get a cash dividend, D 1, and sell the stock for a price P 1. At a given investors required rate of return (ks), what is the value of this stock today? The value of stock today, P0 , is determined by getting sum of present value of the expected dividends per share at the end of year and present value of the expected price of the share after a year. In other words, in the capitalization of cash flow valuation method, the discounted present value of the expected cash flows from the stock is calculated as follows:
P0 = + = (6.5)

For example, if XYZ Company common stock is expected to pay Rs 15 dividend and sell for Rs 125 at the end of one period. What is the value of this stock to an investor who requires a 20 percent rate of return? The answer is computed as follows.
P0 = = = Rs 116.67

Thus, the investor who purchases the stock for Rs 116.67 receives Rs 15 dividend, and sells the stock for Rs 125 at the end of the period will earn 20 percent required rate of return. If actual price of the stock in the market is less than Rs 116.67, the investor should purchase the stock. But if the stock is selling at more than Rs 116.67, the rational investor should not buy it.

MultiperiodValuation
When investor plans to purchase a common stock and hold it for a number of years/periods then sell it in the market, a multiple holding period (or multi-period) model is needed. Single period valuation can be generalized to a multi-period case. The expected cash flows to the investor who purchases a share of common stock and holds it for n

periods consists of dividend payments during each of the next n periods plus selling price of the stock at the end of n th year. Capitalizing their expected cash flows at investors required rate of return, ks, gives the following valuation equation:
P0 = + + . . . + (6.6)

For example, assume an investor is looking for a four-year investment. The share of Everest Company is expected to pay a dividend of Rs 15 per share at the end of first and second year and Rs 20 and Rs 30 respectively at the end of third and fourth years If the investor's capitalization rate is 15 percent and the share's price at the end of fourth year is expected to be Rs 160, compute value of stock today.
P0 = = = = + + Rs Rs +...+ + + 13.04 + 11.34 + 13.15 + 108.63 146.16

PREFERRED STOCK
PREFERRED STOCK

A hybrid security with combined features of both debt and common stock and promises to pay fixed dividend. Preferred stock has preference over common stock in the payment of dividends and claims on assets

Preferred stock, also called preference share, represents the longterm source of financing. It occupies an intermediate position between long-term debt and common stock. In the event of liquidation, a preferred stockholder's claim on assets comes after that of creditors but before that of common stockholders. Similarly, while distributing income preferred stock dividend is distributed after payment of interest but before distribution of common stock dividend. Preferred stock is a hybrid form of financing with combined features of both debt (or bond) and common stock. It is similar to debt in some respects and to common stock in others. Like common stock, preferred stock is legally considered as ownership capital, nonpayment of preference dividends does not force the company into bankruptcy and dividend is paid out of after-tax profit. On the other hand, like bonds, preferred stock has a par value, preferred stock dividends are fixed in amount and generally, preferred stockholders have no voting right. Often, preferred stocks carry credit ratings much like those of bonds and preferred stocks are often callable. Although preferred stock carries a fixed dividend, the actual payment of a dividend is discretionary. When companys after-tax profit is insufficient to pay dividend or company does incurs loss, company can omit or postpone the preferred stock dividend. Such omission of a dividend does not constitute default or insolvency of the company. Hence, preferred stocks are less risky than bonds. From companys point of view, however, they are riskier than bonds to the investors. It is because there is no certainty of getting dividend and bonds have priority over preferred stock on asset in the event of liquidation.

With the development of capital market, different types of preferred stocks with new features have been innovated. Some features, however, are common to all types of preferred stocks while some features are specific to certain types of preferred stock only. Some important features are discussed below. Par Value Par value is stated price in the certificate of preferred stock. Like bonds, the preferred stocks always have par value. This par value is important for two reasons. First, the par value shows the amount due to the preferred stockholders in the event of liquidation or maturity. Second, the preferred stock dividend frequently is expressed as a percentage of par value. Hence, par value is important to compute amount of dividend. Fixed dividend Preferred stockholders get fixed amount of dividend. Preferred stock dividend may be expressed in amount or stated as a percentage of par value. However, company can omit or postpone the preferred stock dividend if company suffers loss.

Maturity Preferred stock, legally is ownership capital and forms a part of firms total equity capital. A firm generally, issues preferred stock s without specified maturity date. But in recent years companies have also issued preferred stocks with specified maturity. In Nepal, companies have issued preferred stocks with specified maturity period. Cumulative feature
Cumulative preferred stock Preferred stock for which all passed (unpaid) dividends must be paid before payment of dividend to common stockholders
NON-CUMULATIVE PREFERRED STOCK

Most preferred stocks are cumulative in nature. It means the unpaid dividend in any year is carried forward. Cumulative preferred stock requires such past unpaid preferred stock dividends to be paid before any common stock dividends are declared and paid. Cumulative feature protects the interest of preferred stockholders and reduces their level of risk. If preferred stock is non-cumulative, unpaid dividends do not accumulate. Investors do not prefer noncumulative preferred stock. Since preferred stockholders do not have dividend enforcement power, the cumulative feature is necessary to protect their interest and right.

Preferred stock for which passed (un paid) dividends do not accumulate

Participating Feature
PARTICIPATING FEATURE PREFERRED STOCK

Preferred stock that allows the preferred stockholders to participate with common stockholders in residual earnings of the firm

Only few preferred stocks have a participating feature, which allows the preferred stockholders to participate with common stock in the residual earnings of the firm. The preferred stockholders might be entitled to share equally with common stockholders if common stock dividend is beyond a certain amount or there may be some specified formula. Virtually, preferred stocks are non-participating, hence

preferred stock dividend does not increase, even if the companys earnings increase. Voting Rights Unlike common stockholders, generally, preferred stockholders do not have the right to vote for the companys board of directors. In other words, as preferred stockholders get prior claim on income and assets, they are not normally given a voice in management. However, preferred stockholders are given special voting right if the company omits its preferred stock dividends for a specified period. Claims on asset and income Preferred stock bears its name because it usually has preference or priority over common stock with regard to companys dividends and assets. At the time of liquidation, preferred stockholders' claim is satisfied after the bondholders' claim in satisfied. But they have prior claim before that of common stockholders. Similarly, preferred stockholders also have a claim on income prior to common stockholders. Firm must pay its preferred stock dividends before it pays common stock dividend. Call Feature
CALL PROVISION

The provision that gives the firm the right to redeem the security before maturity usually at a premium

Like bonds, preferred stock is generally callable. A call provision gives the issuing firm the right to call the preferred stock for redemption at a specified price. The specified price at which preferred stock is called is known as call price, which is usually higher than the par value. The amount in excess of par value is termed as call premium. This call feature allows the issuing company a measure of flexibility in its financing plan, but on the other hand, it increases the risk to the investors.

Conversion Features
CONVERSION FEATURE

A special feature that gives the holder right to convert the preferred stock into specified number of common stock

Preferred stock may contain conversion feature. A convertible preferred stock can be converted into specified number of common stocks at the holders desire within specified period of time. This feature helps to attract potential investors and reduce dividend rate.

Sinking Fund In recent years, preferred stocks are issued with sinking fund provision. A sinking fund provision ensures the orderly retirement of the stock. Adjustable-rate and payment-in-kind (PIK) preferred stock
ADJUSTABLE RATE PREFERRED STOCK

Preferred stock whose dividend rate is tied to interest rates on specific government securities

Now a days adjustable rate and payment in kind (PIK) preferred stocks are also issued by some firms. In the USA adjustable rate preferred stocks (ARPS) have a dividend rate that is tied to the interest rates on specific government securities. Another recent innovation in preferred stock financing is payment-in-kind (PIK) preferred stock. Dividend on such stock is usually paid in the form of additional shares of preferred stock or in kind instead of cash dividend.

PreferredStockValuation
PAYMENT-IN-KIND (PIK)

Preferred stock preferred stock that pays dividends in additional shares of preferred stock

Most preferred stocks entitle their owners to fixed dividend at regular intervals. If the payments last forever this is a perpetuity whose value (Vps) is calculated as
VPs =
Where, VPs = current intrinsic value of preferred stock DPs = current annual cash dividend kps = investor's required rate of return

(6.11)

For example, assume ABC Company is considering raising funds with a preferred stock issue that will pay a 12 percent dividend and have Rs 100 par value. Your required rate of return is 15 percent on this preferred stock.
Value of preferred stock should be Rs 80 i.e. Vps =

Company can also issue preferred stock with specified maturity period, which is redeemable preferred stock. A redeemable preferred stock makes periodic equal dividend payment at the end of each period and principal amount at maturity. Value of redeemable preferred stock is present value of fixed dividend per period throughout the maturity plus present value of principal that is received at maturity. It can be determined using following equation:
Vps = + = Dps PVIFAkps, n + M PVIFkps, n (6.12) (6.12.a)

To illustrate the valuation of redeemable preferred stock assume, Shikhar Company is considering raising funds with a preferred stock issue that will pay a 14 percent dividend and have Rs 100 par value.

The preferred stock matures in 15 years. Investors required rate of return is 15 percent on this preferred stock. What should be the value of preferred stock?
Given, Par value = Rs 100 Dividend rate = 14% Maturity period = 15 years Investors required rate of return (kps) = 15% We have, Vps = + = Dps PVIFAkps,n + M PVIF kps,n = Rs 14 PVIFA15%, 15 + Rs 100 PVIF15%, 15 = Rs 14 5.8474 + Rs 100 0.1229 = Rs 81.86 + Rs 12.29 = Rs 94.15

Virtually most of preferred Stock issues have a call feature. When valuing a preferred stock that is expected to be called, we can apply a modified version of the formula used for valuing a preferred stock with a finite maturity. The Call price replaces the maturity value in equation 7.10.

ILLUSTRATIVE PROBLEMS
Illustration 1.
Common stock valuation

Following information are given to you. Last year's dividend per share Rs 12 Investor's required rate of return 15%. Required: Value of the common stock under following condition a. Dividend remains constant forever. b. Dividend is expected to grow at a constant rate of 5% for ever. c. Dividend is expected to decline at a constant rate of 5% per year. a. Last year's dividend (D0) = Rs 12 Investor's required rate of return (ks) = 15% Value of stock today (P0) =? We have, P0 = = = Rs 80 b. Last year's dividend per share (D0) = Rs 12 Investors required rate of return (ks) = 15% Growth rate in dividend (g) = 5% Value of stock today (P0) =?

SOLUTION

We have, P0 = = = = Rs 126 c. Last year dividend per share (D0) = Rs 12 Investors required rate of return (ks) = 15% Growth rate in dividend (g) = - 5% Value of stock today (P0) =? We have, P0 = = = = Rs 57
Illustration 2.
Common stock valuation

Bagmati Textile Company's common stock paid a dividend of Rs 8 yesterday. You expect the dividend to grow at the rate of 10% per year for the next three years and if you buy the stock you plan to hold it for 3 years and then sell it. a. Find expected dividend for each of the next 3 years. b. Given that the appropriate discount rate is 15 percent and that the first of these dividend payments will occur 1 year from now, find the present value of the dividend stream. c. You expect the price of stock 3 years from now to be Rs 234.26 compute PV of expected future price or PV of P3. d. If you plan to buy the stock, hold it for 3 years and then sell it for Rs 234.26, what is the most you should pay for it? e. Compute value of stock today assuming stock will be purchased and held for ever. Assume growth rate is 10 percent forever. a. Last year dividend per share (D0) = Rs 8 Growth rate for the next 3 years (g) = 10% D1 = D0 (1 + g) = Rs 8 (1.10) = Rs 8.8 D2 = D0 (1 + g)2 = Rs 8 (1.10)2 = Rs 9.68 D3 = D0 (1 + g)3 = Rs 8 (1.10)3 = Rs 10.65 PV of dividends = ? PV of dividends = + + = + + = Rs 7.65 + Rs 7.32 + Rs 7.00 = Rs 21.97 PV of P3 = ? PV of P3 = = = Rs 154.03 PV of stock or maximum money that can be paid for stock = PV of dividend + PV of stock price that will be received at the end of 3 year. = Rs 21.97 + Rs 154.03 = Rs 176

SOLUTION

b.

c.

d.

e.

P0 P0

=? = = = = Rs 176

Illustration 3.
Common stock valuation

Compute the value of following stock: a. A stock paid Rs 14 dividend per share which is expected to be continued forever. b. A stock paid Rs 8 dividend per share in last year. Dividend is expected to grow at a constant rate of 6 percent forever. c. A stock paid Rs 16 dividend per share in last year. Dividend is expected to grow at 10% for next 2 years, at 8% in the third year and then remain constant at 6% forever. Assume investors require 20 percent return a. Given, Dividend per share (DPS) = Rs 14 Investor's required rate of return (ks) = 20% P0 = = = Rs 70 b. Given, Last years dividend per share (D0) = Rs 8 Constant growth rate (g) = 6% Investors required rate of return (ks) = 20% P0 = = = = Rs 60.57 c. Last year's dividend per share (D0) = Rs 16 Growth rate for first 2 years (gs) = 10% Growth rate in the third year (gs) = 8% and thereafter 6% (gc) forever Investors required rate of return (ks) = 20% D1 = D0 (1 + gs) = 16 (1 + 0.1) = Rs 17.6 D2 = D1 (1 + gs) = 17.6 (1 + 0.1) = Rs 19.36 D3 = D2 (1 + gs) = 19.36 (1 + 0.08) = Rs 20.91 P3 = = = = Rs 158.28 Now, P0 = + + + = + + + = 14.67 + 13.44 + 12.10 + 91.6 = Rs 131.81

SOLUTION

Illustration 4.
Common stock valuation and yield

Chaudhary Automobile Company is experiencing a period of repaid growth. Earnings and dividends are expected to grow at a rate of 12 percent during the next 2 years, at 10 percent in the third year, and at a constant rate of 5% thereafter. Company's last dividend was Rs 10, and the required rate of return on the stock is 15 percent. a. Calculate the value of the stock today. b. Calculate P1 and P2. c. Calculate the dividend yield and capital gain yield for year 1, 2 and 3. Given, Last year dividend (D0) = Rs 10 Growth rate for 1st 2yrs. (gs) = 12% Growth rate for 3rd yrs. (gs) = 10% There after growth rate forever (gc) = 5% Investors required rate of return (ks) = 15% P0 = ? We have, P0 = + + + D1 = D0 (1 + gs) = Rs 10 (1 + 0.12) = Rs 11.2 D2 = D1 (1 + gs) = Rs 11.2 (1 + 0.12) = Rs 12.544 D3 = D2 (1 + gs) = Rs 12.544 (1 + 0.10) = Rs 13.80 P3 = = = Rs 144.88 a. P0 = + + + = Rs 9.74 + Rs 9.485 + Rs 9.07 + Rs 95.26 = Rs 123.56 b. (i)P1 = + + = + + = Rs 10.91 + Rs 10.43 + Rs 109.55= Rs 130.89 (ii) P2 = = = Rs 12 + Rs 125.98 = Rs 137.98 c. Calculation of dividend yield and capital yield
Year Div. yield = Capital Yield = = Total Return

SOLUTION

1 2 3
Illustration 5.
Common stock valuation

= 9.06% = 9.58% = 10%

= 5.93% = 5.42% = 5%

15% 15% 15%

Bagmati Textile Company is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 15 percent during the next 4 years, and at a constant rate of 6% thereafter. Company's last dividend was Rs 10, and the required rate of return on the stock is Rs 12 percent. Calculate the value of the stock today. Given, Last year's dividend per share (Do) Growth rate for the first 4 years (gs) Thereafter, growth rate forever (gc) Investors required rate of return (ks) Required value of the stock at present We know, P0 = + + + +

SOLUTION

= = = =

Rs 10 15% 6% 12%

Where, P0 = value of stock D0 = last years dividend gs = super growth rate gc = constant growth rate ks = investors required rate of return.

Again, Dt D1 D2 D3 D4 P4

= Do (1 + g)t

= D0 (1 + gs) = Rs 10 (1 + 0.15) = Rs 11.5 = D1 (1 + gs) = Rs 11.5 (1 + 0.15) = Rs 13.225 = D2 (1 + gs) = Rs 13.225 (1 + 0.15) = Rs 15.2087 = D3 (1 + gs) = Rs 15.2087 (1 + 0.15) = Rs 17.49 = = = = Rs 308.99 Now substituting the values; P0 = + + + + = = Rs 10.27 + Rs 10.55 + Rs 10.82 + Rs 11.12 + Rs 196.43 = Rs 239.18 Therefore, the value of stock today is Rs 239.18
Illustration 6.
Non-constant growth

Rapti Textile Company is expected to pay dividends of Rs 16, Rs 18 and Rs 20 in the next three years- D1, D2 and D3 respectively. After three years, the dividend is expected to grow at a constant rate equal to 8 percent per year indefinitely. Stockholders require a return of 18% to invest in the common stock of Rapti Textile Company. a. Compute the present value of the dividends Rapti Textile Company is expected to pay over the next three years. b. For what price should investors expect to be able to sell the common stock of Rapti Textile Company at the end of three years? c. Compute the value of Rapti Textile Company 's common stock today, P 0. Given, D1 = Rs 16 D2 = Rs 18 D3 = Rs 20 Constant growth rate per year indefinitely (g) = 8% Investors' required rate of return (ks) = 18% a. Calculation of present value of dividends Year Dividend Amount (Rs ) PVIFE18% 1 D1 Rs 16 0.8475 2 D2 Rs 18 0.7182 3 D3 Rs 20 0.6086 Price of stock at the end of year three (P3) = = = = Rs 216 Value of stock today (P0) = + + + = + + + = Rs 13.56 + Rs 12.93 + Rs = Rs 170.12 PV Rs 13.56 Rs 12.93 Rs 12.17

SOLUTION

b. c.

12.17 + Rs 131.46

Illustration 7.
Valuation of firm (TU 2061)

Kosi Corporation is a fast-growing supplier of office products. Analysts project the following free cash flows during the next 3 years, after which free cash flow is expected to grow at a constant 7 percent rate. Koshi's weighted average cost of capital is 13 percent. Time Free cash flow ( in millions) a. b. c. 1 Rs 20 2 Rs 30 3 Rs 40

What is Kosi's terminal or horizon value? What is the value of the firm today? Suppose company has Rs 100 million in debt and 10 million shares of stock. What is the price per share? Terminal or horizon value = = = Rs 713.33 million The value of the firm today Year 1 2 3 FCF (in million) Rs 20 30 40 PVIF at 13% 0.8850 0.7831 0.6931 Total PV of FCF PV (in million) Rs 17.7 23.493 27.724 33.517

SOLUTION

a.

b.

Value of the firm today

c.

= = = = = Value of common equity = Price per share = = =

Total PV of FCF + PV of terminal value Rs 33.517 m + Rs 713.33 m PVIF13%, 3 year Rs 33.517 m + Rs 713.33 m 0.6931 Rs 33.517 m + Rs 494.4090 m Rs 527.926 million = Value of firm today - Value of debt Rs 527.926 m 100 m = Rs 427.926 m

Rs 42.80

PROBLEMS
61
Common stock valuation

In each of the following cases you are required to calculate value of common stocks, assuming, investors require 15 percent return. a. A stock that pays dividend Rs 10 per share, which is expected to remain at Rs 10 forever. b. A stock that recently paid dividend Rs 40 per share, which is expected to grow at a constant rate of 5 percent per year forever. c. A Company is expected to pay a Rs 8 per share dividend at the end of the year (i.e., D1 = Rs 8). The dividend is expected to grow at a constant rate of 6 percent a year. The required rate of return on the stock, ks, is 14 percent.

62
Common stockholder expected return

Lumbini Steel Companys common stock currently sells for Rs 180 per share. The company's executives anticipate a constant growth rate of 10 percent and an end-of-year dividend of Rs 9.

a. What is your expected rate of return if you buy the stock for Rs 180? b. If you require a 13 percent return, should you purchase the stock?
Common stock valuation

63

The common stock of a company paid Rs 8 in dividends last year. Dividends are expected to grow at a 10 percent annual rate for an indefinite number of years. a. If company's stock current market price is Rs 176, what is the stock's expected rate of return? b. If your required rate of return is 14 percent, what is the value of the stock for you? c. Should you make the investment? Investors require a 15% rate of return on ND Company's stock (ks = 15%). a. What will be ND's stock value if the previous dividend was Do = Rs 10 and if investors expect dividends to grow at a constant compound annual rate of (1) 5% (2) 0 percent (3) 5% and (4) 10%? b. Using data from part a, what is the Gordon (constant growth) model value for ND's stock if the required rate of return is 15% and the expected growth rate is (1) 15% or (2) 20% ? Are these reasonable results? Explain. c. Is it reasonable to expect that a constant growth stock would have g > ks?

64
Common stock valuation

65
Common stock valuation

Sahara Company presently pays a dividend of Rs 16 per share on its common stock. The company expects to increase the dividend at a 15 percent annual rate the first two years and at a 10 percent rate the next three years and then grow the dividend at a 5 percent rate thereafter. This phased-growth pattern is in keeping with the expected life cycle of earnings. You require a 12 percent return to invest in this stock. What value should you place on a share of this stock? XYZ, Inc., has an odd dividend policy. The company has just paid a dividend of Rs 12 per share and has announced that it will increase the dividend by Rs 6 per share for each of the next four years, and then never pay another dividend. If you require an 10 percent return on the company's stock, how much will you pay for a share today? MT Company's stock recently paid a Rs 20 dividend. This dividend is expected to grow by 25 percent for the next 3 years, and then grow forever at a constant rate, g. The current stock price is Rs 588.8. At what constant rate is the stock expected to grow following year if ks = 12%? Just today, Triveni, Inc.'s common stock paid a Rs 12 annual dividend per share and had a closing price of Rs 157.5. Assume that the market's required return, or capitalization rate, for this investment is 13 percent and that dividends are expected to grow at a constant rate forever. a. Calculate the implied growth rate in dividends. b. What is the expected dividend yield? c. What is the expected capital gains yield?

66
Non-constant dividends

67
Supernormal growth valuation

68
Growth rate and yield

69
Supernormal growth valuation

Kantipur Enterprises recently paid a dividend, D 0, of Rs 12.5. The company expects to have supernormal growth of 20 percent for 2 years before the dividend is expected to grow at a constant rate of 5 percent. The firm's cost of equity is 10 percent. a. What year is the terminal, or horizon, date? b. What is the firm's horizon, or terminal, value? c. What is the firm's intrinsic value today, P0? NDC's preferred stock is selling for Rs 80 in the market and pays a Rs 12 annual dividend. a. What is the expected rate of return on the stock? b. If an investor's required rate of return is 10 percent, what is the value of the stock for that investor? Should the investor acquire the stock? Vishal Trading Company is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect VT to begin paying dividends, with the first dividend of Rs 4 coming 3 years from today. The dividend should grow rapidly- at a rate of 20 percent per year- during Years 4 and 5. After Year 5, the company should grow at a constant rate of 6 percent per year. If the required return on the stock is 12 percent, what is the value of stock today? A share of preferred stock for the B & B Company just sold for Rs 100 and carries an Rs 12 annual dividend. a. What is the yield on this stock? b. Now assume that this stock has a call price of Rs 110 in five years, when the company intends to call the issue. ( Note: The preferred stock in this case should not be treated as a perpetual it will be bought back in five years for Rs 110.) What is this preferred stock's yield to call?

610
Preferred stock valuation

611
Non-constant growth

612
Stock price and return

Problems: 6.1 a. P0 = 66.67 b. P0 = Rs 420 c. P0 = Rs 100 6.2 a. 15% 6.3 a. k = 15%; b. Rs 220 6.4 a. 1.Po = Rs 47.50, 2. P0 = Rs 66.67, 3. P0 = Rs 105, 4. P0 = Rs 220; b. 1. P0 = (infinite), 2. P0 = Rs 240 are meaningless results; c. It is not reasonable; k s > g is necessary for the derivation of Gordon Model. 6.5 P0 = Rs 321.91 6.7 6.25% 6.9 b. Rs 378, c. Rs 340.9 6.11 6.12 6.6 Rs 83.32 6.8 a. g = 5%, b. = 8%, c. = 5% 6.10 a. 15% b. Rs 120 P0 = Rs 66.91 a. 12%, b. 13.53%.