Professional Documents
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CHAPTER 8
Valuation and Characteristics
of Stock
CHAPTER ORIENTATION
This chapter continues the introduction begun in Chapter 7 of the concepts underlying asset
valuation. We are specifically concerned with valuing preferred stock and common stock. We
also look at the concept of a stockholders expected rate of return on an investment.
CHAPTER OUTLINE
I. Preferred Stock
A. Features of preferred stock
1. Owners of preferred stock receive dividends instead of interest.
2. Most preferred stocks are perpetuities (non-maturing).
3. Multiple classes, each having different characteristics, can be issued.
4. In the case of bankruptcy, preferred stock has priority over common
stock with regard to claims on assets.
5. 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.
6. Preferred stock may contain other protective provisions.
7. Preferred stock contains provisions to convert to a predetermined
number of shares of common stock.
8. Retirement features for preferred stock are frequently included.
a. Callable preferred refers to a feature which allows preferred
stock to be called or retired, like a bond.
b. A sinking fund provision requires the firm to periodically set
aside an amount of money for the retirement of its preferred
stock.
D1 D2 D
Vcs = + +...+
(1 + rcs )1
(1 + rcs ) 2
(1 + rcs )
Dt = D0 (l + g)t
where g = the growth rate
D0 = the most recent dividend payment
If the growth rate, g, is the same each year and is less than the
required rate of return, rcs, the valuation equation for common
stock can be reduced to
D1 D 0 (1 + g)
Vcs = =
rcs - g rcs - g
ANSWERS TO
END-OF-CHAPTER QUESTIONS
8-1. Preferred stock is commonly referred to as a hybrid security. This is because preferred
stock has many characteristics of both common stock and bonds. It has characteristics
of common stock: no fixed maturity date, the nonpayment of dividends does not force
bankruptcy, and the nondeductibility of dividends for tax purposes. Preferred stock is
similar to bonds because the dividends are fixed in amount, like interest payments.
From the point of view of the preferred stock shareholder, this is not the most
delightful combination. On one hand, the dividends are limited as with bonds, but the
security of forced payment by the threat of bankruptcy is not there. Thus, from the
point of view of the investor, the worst features of common stock and bonds are
combined.
8-2. To a certain extent, preferred stock dividends can be thought of as a liability. The major
difference between preferred dividends in arrears and normal liabilities is that
nonpayment of them cannot force the firm into bankruptcy. However, since the goal of
the firm is shareholder wealth maximization, which involves getting money to the
shareholders (dividends), preferred arrearages provide an effective block for the goal of
the firm.
8-3. A cumulative feature requires all past unpaid preferred stock dividends be paid before
any common stock dividends are declared. A stockholder would like preferred stock to
have a cumulative dividend feature because without it there would be no reason why
preferred stock dividends would not be omitted or passed when common stock
dividends were passed. Since preferred stock does not have the dividend enforcement
power of interest as bonds do, the cumulative feature is necessary to protect the rights
of preferred stockholders.
Other protective features generally serve to allow for voting rights in the event of
nonpayment of dividends, or they restrict the payment of common stock dividends if
sinking-fund payments are not met, or if the firm is in financial difficulty. In effect, the
protective features included with preferred stock are similar to the restrictive provisions
included with long-term debt.
8-4. Convertibility allows a preferred stockholder to convert or exchange preferred stock for
shares of common stock at a predetermined exchange rate. This option gives preferred
stockholders more freedom in their investment decisions, by allowing them to convert
into common stock at their discretion.
Preferred stock may be callable by the issuer so that in the event that interest rates
decline, and cheaper funding becomes available, the stock may be called and new
securities may be issued at a lower cost. To agree to the call feature, the investor will
require a slightly higher rate of return.
8-5. Both values are based on future cash flows to be received by stockholders. Preferred
stock typically has a predetermined constant dividend. For common stock, the dividend
is based on both the profitability of the firm and managements decision to pay
dividends or to retain the profits for reinvestment purposes. Thus, the growth of future
dividends is a prime distinguishing feature of common stock.
8-6. The expected rate of return is the rate of return that may be expected from purchasing a
security at the prevailing market price. Thus, the expected rate of return is the rate that
equates future cash flows with the actual selling price of the security.
8-7. The expected rate of return is the discount rate that equates the present value of future
expected cash flows with the value of the security.
8-8. The two types of return include dividend income and capital gains. Dividend income
for common stockholders differs from preferred stockholders, in that no specified
dividend amount is to be received. However, common stockholders are permitted to
participate in the growth of the company. Price appreciation is a result of this growth
(their second source of return).
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
8-1.
A B
You would choose stock A, which has an expected rate of return greater than your
required rate of return12.86 percent versus 12 percent. On the other hand, stock Bs
expected rate of return does not meet your required rate of return.
Thus:
growth rate
Retention rate = return on equity
.07
= = .58 or 58%
.12
$3.25(1+ .0633)
= + 0.0633 = 01496 or 14.96%
$40
c. Since the stock has an expected rate of return of 14.96 percent, which is greater
than your 13-percent required rate of return, you should invest.
$1 + growth rate
$32.50 = .12 growth rate
$32.50(0.12 g) = $1 + g,
$3.90 - $32.50g = $1 + g
$2.90 = $33.50g
g = 0.0866 or 8.66%
=
=
= $116.67
$50 = +
Rearranging and solving for P1:
P1 = $50 (1.15) - $6
P1 = $51.50
The stock would have to increase $1.50 ($51.50 - $50) or 3 percent ($1.50/$50) to earn
a 15% rate of return.
k cs = 18.9%
b. Vcs = = $28.57
Yes, purchase the stock. The expected return is greater than your required rate of
return. Also, the stock is selling for only $22.50, while it is worth $28.57 to you.
Vcs =
Vcs = $24.50
Vcs = +
Vcs = $39.96
k cs = - 1
k cs = - 1 = 0.1823
k cs = 18.23%
8-15. a. k ps = = = 10.91%
b. Value (Vps) = = = $36
c. The investor's required rate of return (10 percent) is less than the expected rate
of return for the investment (10.91 percent). Also, the value of the stock to the
investor ($36) exceeds the existing market price ($33). So buy the stock.
D 6
8-17. Vps = = $50 per share
k ps .12
Dividend $1.55
Expected return = Selling Price
= = 0.0704 or 7%
$22.00
Dividend $1.55
Value = Required Rate of Return
= = $17.22
9%
This stock is worth $17.22 to you (less than the market price of $221), so you should
not buy the stock.
12
6
87.50
1000
ANSWER -1230.56
10
$87.50 $1,000
Vb = (1 + .06) t
+
(1 + .06)12
t 1
= $87.50(7.3601) + $1,000(.55839)
= $644.01 + $558.39
= $1,230.56
However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to
Vps =
$2.50
=
.07
= $35.71
Company's earnings have increased from $2.40 to $4.48 in five years. What
annual compound growth rate would cause an investment to increase in five
years?
= 15.48%
$1.32(1 + .1548) t
Vcs =
t 1 (1 + .15) t
If the percent growth rate (g) is assumed constant, the equation may be reduced
to
Vcs =
$1.320(1 + 0.1548)
=
.15 .0.1548
1.5243
=
0.0048
= $317.56
Choose only the preferred stock because it is the only security selling for a price lower
than the value of investment based on your required rate of return.
c. Common Stock:
Growth Rate (g) = 13.3% - 3% = 10.3%
Vcs =
$1.32(1 + 0.1248)
=
.15 0.1248
1.4847
=
0.0252
= $58.92
Your Value Selling Price
Common Stock 58.92 36.75
You would prefer not to buy the Emerson Electric stock because its selling price is
lower than the investment based on your required rate of return.
d. Bond:
10
$87.50 $1,000
$1,314 =
t 1 (1 + k b ) t
+
(1 + k b )10
12
1,314
87.50
1000
ANSWER 5.17
Preferred Stock:
Vps =
2.50
Required Rate of Return =
25.5
= 9.8%
Common Stock:
Vcs =
$1.32(1 + 0.1548)
80 =
k 0.1548
1.5243
k = + 0.1548
36.75
= 19.63%
ALTERNATIVE PROBLEMS
8-1A. (Preferred Stock Valuation) What is the value of a preferred stock where the dividend
rate is 16 percent on a $100 par value? The appropriate discount rate for a stock of this
risk level is 12 percent.
8-2A. (Preferred Stockholder Expected Return) Shewmakers preferred stock is selling for
$55.16 and pays $2.35 in dividends. What is your expected rate of return if you
purchase the security at the market price?
8-3A. (Preferred Stockholder Expected Return) You own 250 shares of McCormick
Resources preferred stock, which currently sells for $38.50 per share and pays annual
dividends of $3.25 per share.
a. What is your expected return?
b. If you require an 8 percent return, given the current price, should you sell or
buy more stock?
8-4A. (Common Stock Valuation) You intend to purchase Bama, Inc., common stock at
$52.75 per share, hold it one year, and sell after a dividend of $6.50 is paid. How much
will the stock price have to appreciate if your required rate of return is 16 percent?
8-5A. (Common Stockholder Expected Return) Blackburn & Smiths common stock currently
sells for $23 per share. The companys executives anticipate a constant growth rate of
10.5 percent and an end-of-year dividend of $2.50.
a. What is the expected rate of return if you buy the stock for $23?
b. If you require a 17 percent return, should you purchase the stock?
8-6A. (Common Stock Valuation) Gilliland Motor, Inc., paid a $3.75 dividend last year. At a
constant growth rate of 6 percent, what is the value of the common stock if the
investors require a 20 percent rate of return?
8-7A. (Measuring Growth) Given that a firms return on equity is 24 percent and management
plans to retain 60 percent of earnings for investment purposes, what will be the firms
growth rate?
8-8A. (Common Stockholder Expected Return) The common stock of Bouncy-Bob Moore
Co. is selling for $33.84. The stock recently paid dividends of $3 per share and has a
projected constant growth rate of 8.5 percent. If you purchase the stock at the market
price, what is your expected rate of return?
8-9A. (Common Stock Valuation) Honeybee common stock is expected to pay $1.85 in
dividends next year, and the market price is projected to be $40 by year end. If the
investors required rate of return is 12 percent, what is the current value of the stock?
8-10A. (Common Stock Expected Rate of Return) The market price for M. Simpson & Co.s
common stock is $44. The price at the end of one year is expected to be $47, and
dividends for next year should be $2. What is the expected rate of return?
8-11A. (Preferred Stock Valuation) Grees preferred stock is selling for $35 in the market and
pays a $4 annual dividend.
a. What is the expected rate of return of the stock?
b. If an investors required rate of return is 10 percent, what is the value of the
stock to the investor?
c. Should the investor acquire the stock?
8-12A. (Common Stock Valuation) The common stock of KPD paid $1 in dividends last year.
Dividends are expected to grow at an 8 percent annual rate for an indefinite number of
years.
a. If KPDs current market price is $25, what is the stocks expected rate of
return?
b. If your required rate of return is 11 percent, what is the value of the stock to
you?
8-1A. Value(Vps) =
= $133.33
b. Given your 8 percent required rate of return, the stock is worth $40.62 to you
Value = = = $40.625
Since the expected rate of return (8.44%) is greater than your required rate of
return (8%) or since the current market price ($38.50) is less than $40.62, the
stock is undervalued and you should buy.
$52.75 = +
The stock would have to increase $1.94 ($54.69 - $52.75) or 3.6 percent ($1.94/$52.75)
to earn a 16% rate of return.
Expected
8-5A. a. rate of return = +
Expected
rate of return = + .105 = .2137 = 21.37%
cs
b. Vcs = = $38.46
The expected rate of return exceeds your required rate of return, which means
that the value of the security to you is greater than the current market price.
Thus, you should buy the stock.
Vcs =
Vcs = $28.39
Expected rate
= + 0.085 = 0.181 = 18.1%
of return
Vcs = +
Vcs = $37.37
_
8-10A. If the expected rate of return is represented by :
k cs
Dividend in Year 1 Price in Year 1
Current Price = +
(1 + expected return) (1 + expected return)
Expected rate
= - 1
of return
Expected rate
= - 1 = 0.1136
of return
Expected rate
= 11.36%
of return
8-11A. a. k ps = = = 11.43%
c. The investor's required rate of return (10 percent) is less than the expected rate
of return for the investment (11.43 percent). Also, the value of the stock to the
investor ($40) exceeds the existing market price ($35). You should buy the
stock.
= + 0.08 = 0.1232
= 12.32%
b. Investor's Value =
= $36.00
c. Yes, the expected rate of return is greater than your required rate of return
(12.32 percent versus 11 percent). Also, your value of the stock ($36.00) is
larger than the current market price ($25.00).
Bond:
12 $140 $1,000
Vb = (1 + .12) t +
(1 + .12)12
t 1
= $140(6.194) + $1,000(.257)
= $867.16 + $257
= $1,124.16
Preferred Stock:
$12
Vps = t
t 1 (1 + .14)
However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to
Vps =
=
= $85.71
Common Stock:
Company's earnings have doubled ($4 to $8) in ten years. What annual
compound growth rate would cause an investment to double in ten years?
Looking in Appendix B (Compound sum of $1) an interest factor of 2.000 for
ten years is closest to seven percent (1.967). Thus, at about seven percent,
money would double in ten years. (The same conclusion could have been
reached by using Appendix D but by using a .500 present value interest factor.)
$3(1 + .07)t
Vcs = t
t 1 (1 + .20)
If the seven percent growth rate (g) is assumed constant, the equation may be
reduced to
Vcs =
= $24.69
b. Your Value Selling Price
Bond $1,124.16 $1,200.00
Preferred Stock 85.71 80.00
Common Stock 24.69 25.00
Buy only the Preferred stock; it is the only investment in which the market
price is less than the value to you.
c. (1) Bond:
12 $140
Vb = (1 + .14) t
+
t 1
= $140(5.660) + $1,000(.2076)
= $792.40 + $207.60
= $1,000.00
Preferred Stock:
Vps =
= $75.00
Do not buy. Your value is less than what you would have to pay for the
stock.
Common Stock:
Vcs =
= $29.18
Buy. Your value is greater than what you would have to pay for the
stock.
Vcs =
= = $42