Payment-in-kind PIK preferred stock, grants the investor additional preferred stock instead of dividends for a given period of time.Eventually cash dividends are paid... Common stock’s v
Trang 1A 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 Preferred stock has priority over common stock with regard to claims
on assets in the case of bankruptcy
5 Most preferred stock carries a cumulative feature that requires all
past unpaid preferred stock dividends to be paid before any commonstock dividends are declared
6 Preferred stock may contain other protective provisions, such as
granting voting rights in the event of non-payment of dividends
7 Preferred stock may contain provisions to convert to a predetermined
number of shares of common stock
8 Some preferred stock contains provisions for an adjustable rate of
return
9 If there is a participation feature, it allows preferred stockholders to
participate in earnings beyond the payment of the stated dividend
10 Payment-in-kind (PIK) preferred stock, grants the investor additional
preferred stock instead of dividends for a given period of time.Eventually cash dividends are paid
Trang 211 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 periodically set
aside an amount of money for the retirement of its preferredstock
B Valuation of preferred stock (Vps):
The value of a preferred stock equals the present value of all futuredividends If the stock is nonmaturing, where dividends are expected inequal amount each year in perpetuity, the value may be calculated asfollows:
Vps = =
II 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 preferredstockholders have been paid
2 Common stockholders are generally the only security holders with
the right to elect the board of directors
3 Preemptive rights (if granted) entitle the common shareholder to
maintain a proportionate share of ownership in the firm
4 Common stockholder’s liability as an owner of the corporation is
limited to the amount invested in the stock
5 Common stock’s value is equal to the present value of all future cash
flows expected to be received by the stockholder
B Valuing common stock
1 Company growth occurs by:
a the infusion of new capital, or
b the retention of earnings, which is called internal growth
The internal growth rate of a firm equals:
Return on equity
2 Although the bondholder and preferred stockholder are promised a
specific amount each year, the dividend for common stock is based
on the profitability of the firm and management's decision either to
Trang 34 The earnings growth of a firm should be reflected in a higher price
for the firm's stock
5 In finding the value of a common stock (Vcs), we should discount all
future expected dividends (Dl, D2, D3, ., D) to the present at therequired rate of return for the stockholder (kcs) That is:
Vcs = 1
cs
1
)k(1
D
+ +
k )(1
D
cs
6 If we assume that the amount of dividend is increasing by a constant
growth rate each year,
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, t, and is less than therequired rate of return, kcs, the valuation equation for common stockcan be reduced to
Vcs = = III Shareholder's Expected Rate of Return
A The shareholder's expected rate of return is of great interest to financial
managers because it tells about the investor’s expectations
B Preferred stockholder's expected rate of return:
If we know the market price of a preferred stock and the amount of the dividends to be received, the expected rate of return from the investment can
C Common stockholder's expected rate of return:
1 The expected rate of return for common stock can be calculated from
the valuation equations previously discussed
Trang 42 Assuming that dividends are increasing at a constant annual growth
rate, g, we can show that the expected rate of return for commonstock, kcs is
k cs = +
= + gSince dividend ÷ price is the "dividend yield," the
Expected rate of return = +
IV Appendix: The Relationship between Value and Earnings
A Earnings and Value Relationship: The nongrowth firm
1 Nongrowth firms retain no profits for reinvestment purposes
a Investments are made to maintain status quo
b Earnings and dividend growth stream is constant from year to
year
2 Value on nongrowth common stock, Vng:
cs
1 cs
1 ng
k
D k
EPS
V
a Value of share changes in direct relationship with changes in
earnings per share
b Changes in the investor’s required rate of return will change
share value
B Earnings and Value Relationship: The growth firm
1 Growth firm reinvests profits back into the business
2 Value of stock equals the present value of the dividend stream plus
the present value of the future growth resulting from reinvesting future earnings
NVDG
k
EPS V
cs
1
a NVDG is the net value of any dividend growth resulting from
reinvestment of future earnings
b Present value (PV1) from reinvesting part of the firms
earnings in year 1 equals:
Trang 5g k
PV NVDG
PV k
EPS V
cs
1 cs
1 cs
3 Value of stock is influenced by
a Size of the firm’s EPS,
b Percentage of profits retained,
c Spread between return generated on new investments and the
investor’s required rate of return
ANSWERS TO END-OF-CHAPTER QUESTIONS
8-1 Preferred stock is often referred to as a hybrid security This is because preferred
stock has many characteristics of both common stock and bonds It hascharacteristics of common stock, such as no fixed maturity date, nonpayment ofdividends does not force bankruptcy, and the nondeductibility of dividends for taxpurposes But it is like bonds because the dividends are fixed in amount likeinterest payments From the point of view of the preferred stockholder, this is notthe most advantageous combination On one hand, the dividends are limited as withbond interest, but the security of forced payment by the threat of bankruptcy is notthere Thus, from the point of view of the investor, the worst features of commonstock 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 thatnonpayment of them cannot force the firm into bankruptcy However, since thegoal of the firm is common shareholder wealth maximization, which involvesgetting money to the common shareholders (dividends), preferred arrearagesprovide a barrier to achieving this goal
8-3 A cumulative feature requires all past unpaid preferred stock dividends be paid
before any common stock dividends are declared A stockholder would likepreferred stock to have a cumulative dividend feature because without it therewould be no reason why preferred stock dividends would not be omitted or passedwhen common stock dividends were passed Since preferred stock does not havethe dividend enforcement power of interest from bonds, the cumulative feature isnecessary to protect the rights of preferred stockholders
Other frequent protective features serve to allow for voting rights in the event ofnonpayment of dividends or to restrict the payment of common stock dividends ifsinking-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 restrictiveprovisions included with long-term debt
Trang 68-4 Fixed rate preferred stock has dividends that do not vary from the fixed amount or
from period to period
Adjustable rate preferred stock is preferred stock that has quarterly dividends thatfluctuate with interest rates under a formula that ties the dividend payment at either
a premium or discount to the highest of the three-month Treasury bill rate, the year Treasury bond constant maturity rate, or the 20-year Treasury bond constantmaturity rate The rates have maximum and minimum levels called the dividendrate band
10-The purpose of allowing the dividend rate to fluctuate is to minimize the fluctuation
in the value of the preferred stock It is also very appealing in times of high andfluctuating interest rates
8-5 With PIK (payment-in-kind) preferred stock, investors receive no dividends
initially; they merely get more preferred stock, which in turn pays dividends in evenmore preferred stock Usually after 5 or 6 years, if all goes well for the issuingcompany, cash dividends should replace the preferred stock dividends, generallyranging from 12 percent to 18 percent, to entice investors to purchase PIKpreferred
8-6 Convertibility allows a preferred stockholder to convert or exchange preferred stock
for shares of common stock at a predetermined exchange rate This option givespreferred stockholders more freedom in investment decisions by allowing them toconvert into common stock at their discretion It gives the preferred stockholder ahigher cash return than the common stock but allows for sharing in some of thefuture appreciation of the common stock if they convert the stock
Preferred stock may be callable by the issuer so that in the event interest ratesdecline and cheaper funding becomes available, the stock may be called and newsecurities may be issued at a lower cost To agree to the call feature, the investorrequires a slightly higher rate of return Call of a convertible preferred stockenables a company to turn the preferred stock into common equity; i.e., calling itwithout having to spend the cash
8-7 Both values are based on future cash flows to be received by stockholders
Preferred stock typically has a predetermined constant dividend For commonstock, the dividend is based on the profitability of the firm and on management’sdecision 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 8-8 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 ofreturn is the rate that equates the present value of future cash flows with the actualselling price of the security in the market
Trang 78-9 The required rate of return is the discount rate that equates the present value of
future cash flows with the intrinsic value of the security As with the internal rate
of return for a capital budgeting problem, we have to find the rate of return that setsthe future cash flows equal to the cost of the security This rate may have to bedeveloped by trial and error
8-10 The two types of return are dividend income and capital gains The dividend
income for common stockholders differs from preferred stockholders, in that nospecified dividend amount is to be received However, the common stockholdersare permitted to participate in the growth of the company As a result of thisgrowth, their second source of return, price appreciation, is realized
= (16%) (60%) = 9.6%
8-3A Value (Vps) = .14 .12$100
=
12
14
$
= $116.678-4A Expected Rate of Return
kps =
Price
Dividend =
16.42
$
95
$
40.3 = 085 = 8.5%
(b) Given your 8 percent required rate of return, the stock is worth $42.50 toyou
Value =
Returnof
RateRequired
Dividend
= 08
40.3 = $42.50
Since the expected rate of return (8.5%) is greater than your required rate ofreturn (8%), or since the current market price ($40) is less than the value($42.50), the stock is undervalued and you should buy
Trang 88-6A Value (Vcs) = (1DividendRequiredin Year Rate)1 +
Rate)Required(1
1Year
in Price
$50 =
)15 1(
6
+
)15 1(
P1
Rearranging and solving for P1:
P1 = $50 (1.15) - $6P1 = $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
8-7A (a)
)k(return of
rateExpected
PriceMarket
1Year
in Dividend
+ rategrowthkcs = $222..0050 + 10
kcs = .1889, or 18.9%
(b) Vcs =
10 17
00.2
= $28.57Yes, purchase the stock The expected return is greater than your requiredrate of return Also, the stock is selling for only $22.50, while it is worth
$28.57 to you
8-8A Value (Vcs) =
Rate)Growth
Rate(Required
Rate)Growth (1
DividendYear
Last
Vcs =Vcs = $24.508-9A Growth rate = return on equity x retention rate
= (18%) (40%) = 7.2%
8-10A Expected Rate of Return (k ) =cs
Price
Rate)Growth (1
DividendYear
Trang 98-11A Value (Vcs) =
Rate)Required(1
1Year
in Dividend
+
Rate)Required(1
1Year
in Price
Vcs =
)11.1(
85.1 +
)11.1(
50.42
$
Vcs = $39.958-12A If the expected rate of return is represented by k :cs
Current Price =
)k(1
1Year
in Dividend
cs
+
)k(1
1Year
in Price
1Year
in Price1
Year
in Dividend
- 1
cs
00.43
$
00.48
$ 84
$
60.3
ps
k = 0.1091, or 10.91%
(b) Value (Vps) = RequiredDividendRateof Return =
10.0
60
3 = $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 thestock to the investor ($36) exceeds the existing market price ($33), so buythe stock
8-14A.(a) Expected Rate of Return =
PriceMarket
1Year
in Dividend
+ RateGrowth
=
50.23
$
)08.1(32.1
+ 0.08
= 0.1407, or 14.07%
(b) Investor's Value =
RateGrowth -
Return of
RateRequired
1Year
in Dividend
=
08.0105.0
)08.1(32.1
= $57.02
Trang 10(c) Yes, the expected rate of return (14.07%) is greater than your required rate
of return (10.5 percent) Also, your value of the stock ($57.02) is greaterthan the current market price ($23.50)
8-15A (a) Dividend yield: Dividend stock price =
49
$
12.1 = 0.0229, or 2.29%
(b) Using the nominal average returns of 12.2% for large-company stocks and
the 3.8% nominal average return for U.S Treasury Bills as shown in Table
6-1, the computation would be as follows:
returnofrate
Expected
=
rate
freerisk + beta
return
freerisk
= 3.8% + 1.10 (12.2% - 3.8%) = 13.04%
(c)
returnofrate
Expected
=
PriceMarket
1Year
in Dividend
Trang 1150.4
ps
k = 0.18, or 18%
(b) Value (Vps) = RequiredDividendRateof Return =
14.0
50
4 = $32.14
(c) The investor's required rate of return (14 percent) is less than the expected
rate of return for the investment (18 percent) Also, the value of the stock
to the investor ($32.14) exceeds the existing market price ($25), so buy thestock
8-18A
(a) Investor's Value =
RateGrowth -
Return of
RateRequired
1Year
in Dividend
=
05.015.0
)05.1(30.2
= $24.15(b) Expected Rate of Return =
PriceMarket
1Year
in Dividend
+ 0.05
= 0.1232, or 12.32%
(c) No, the expected rate of return (12.32%) is less than your required rate of
return (15 percent) Also, your value of the stock ($24.15) is less than thecurrent market price ($33)
8-19A (a) Growth rate = return on equity x retention rate
= (17%) (30%) = 5.1%
(b) (i) If retention rate is 40%:
Growth rate = return on equity x retention rate
= (17%) (40%) = 6.8%
(ii) If retention rate is 25%:
Growth rate = return on equity x retention rate
= (17%) (25%) = 4.25%