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Universidad Tecnológica de El Salvador Maestría en Administración Financiera (MAF).

Matemáticas financieras Tema: Valuación de activos financieros. Profesor: Miguel Ángel Pérez O. Septiembre 2012

Chapter 8

Valuation and Characteristics 1 of Stock
I. Chapter Orientation
This chapter continues the introduction of concepts underlying asset valuation begun in Chapter 7. We are specificallyconcerned with valuing preferred stock and common stock. We also look at the concept of a stockholder’s expected rate of return on an investment.

II. Chapter Outline
I. Preferred Stock A. Features of preferred stock 1. 2. 3. 4. 5. Owners of preferred stock receive dividends instead of interest. Most preferred stocks are perpetuities (non-maturing). Multiple classes, each having differentcharacteristics, can be issued. Preferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy. Most preferred stock carries a cumulative feature that requires all past unpaid preferred stock dividends to be paid before any common stock dividends are declared. Preferred stock may contain other protective provisions.



Keown, Martin, Petty, Scott,Jr., “Foundations of Finance”, Chapter 8, Prentice-Hall, USA, 2007.


7. 8.

Preferred stock contain provisions to convert to a predetermined number of shares of common stock. Retirement features for preferred stock are frequently included. a. b. Callable preferred refers to a feature which allows preferred stock to be called or retired, like a bond. A sinking fund provision requires thefirm periodically to set aside an amount of money for the retirement of its preferred stock.


Valuation of preferred stock (Vps): The value of a preferred stock equals the present value of all future dividends. If the stock is nonmaturing, where dividends are expected in equal amount each year in perpetuity, the value may be calculated as follows: annual dividend D Vps = required rate ofreturn = k ps


Common Stock A. Features of Common Stock 1. As owners of the corporation, common shareholders have the right to the residual income and assets after bondholders and preferred stockholders have been paid. Common stock shareholders are generally the only security holders with the right to elect the board of directors. Preemptive rights entitles the common shareholder tomaintain a proportionate share of ownership in the firm. Common stock shareholders’ liability as owners of the corporation is limited to the amount of their investment. Common stock’s value is equal to the present value of all future cash flows expected to be received by the stockholder. Company growth occurs either by: a. b. The infusion of new capital. The retention of earnings, which we callinternal growth. The internal growth rate of a firm equals: Percentage of earnings Return on equity X  retained within the firm  2. Although the bondholder and preferred stockholder are promised a specific amount each year, the dividend for common stock is based 213

2. 3. 4. 5. B.

Valuing common stock 1.

on the profitability of the firm and the management's decision either to pay dividendsor retain profits for reinvestment. 3. 4. 5. The common dividend typically increases along with the growth in corporate earnings. The earnings growth of a firm should be reflected in a higher price for the firm's stock. In finding the value of a common stock (Vcs), we should discount all future expected dividends (Dl, D2, D3, ..., D∞) to the present at the required rate of return for thestockholder (kc). That is: Vcs = 6.

D2 D∞ + +...+ (1 + k cs )1 (1 + k cs ) 2 (1 + k cs )∞


If we assume that the amount of dividend is increasing by a constant growth rate each year, Dt = D0 (l + g)t where g D0 = the growth rate = the most recent dividend payment

If the growth rate, g, is the same each year and is less than the required rate of return, Kcs, the valuation equation for common...
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