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Preferred stock
◦ Fixed cash flow stream
◦ Dividend payments as a percentage of par value
◦ Cannot force the firm into bankruptcy
◦ Do not carry the right to vote
◦ Cumulative (cannot pay dividend to regular
bondholders unless it makes up for the unpaid
dividends of preferred stocks)
◦ No fixed maturity date
◦ Similar to a perpetuity
Preferred stock valuation
P0 = D1 + D2 + …….+ (Dn+Pn)
(1+r) (1+r)2 (1+r)n
There are two variables that affect a stock
price:
1. Discount rate (firm’s risk)
2. Di id d ((growth)
Dividends h)
DIVIDEND GROWTH
◦ Zero growth
◦ Constant growth
g
◦ Variable growth
◦ Return= (D1+P1) – P0
◦ P0
◦ From the return formula, we can rearrange terms
◦ and get the price at year zero:
◦ r = (D1+P1) – P0
◦ P0 P0
◦ r = (D1+P1) – 1
◦ P0
◦ P0 = (D1+P1)
◦ (1+r)
Zero growth
P0= D/r
D/
Zero growth
Example:
P0= D1/r
/ –g
P 0= 4 3/0
4,3 1–0
0,1 03 $61
0,03= 43
$61,43
Variable growth
Pn= Dn+1/r – g2
Pg2= Pn/(1+r)n
Price of a stock using the variable growth model:
1 3,25
2 3
3,25
25 (1
(1,2)
2)1 = 3,90
3 90
3 3,25 (1,2)2 = 4,68
4 3 25
3,25 (1 2)3
(1,2) = 5 62
5,62
5 5,62 (1,0,04)1 = 5,84
Example:
0 1 2 3 4 5
$3,25 $3,90 $4,68 $5,62 $5,84
Stable growth:
P4 = 5,84
5 84 /0
/0,15
15 – 0,04
0 04 = 53
53,10
10
P0 = 53,10 / (1,15)4 = 30,36
Pg2 = 30 36
30,36
Example:
0 1 2 3 4 5
$3,25 $3,90 $4,68 $5,62 $5,84
Variable growth:
P0 = 3,25/(1,15)1 + 3,90/(1,15)2 + 4,68/(1,15)3 + 5,62/(1,15)4
Pg1= 12,06
Example:
A company retains 75% of its earnings. The
firm’s
firm s net income was 44,6
44 6 millions and the
book value of its equity was 297,33 millions.
What is the firm´s
firm s growth rate?
g = 0,75 x 0,15 = 0,1125 = 11,25%
Free cash flow approach
V
V= total market value of the firms’
firms sources of funds
V= E+D+P 100%= E/V+D/V+P/V
Free cash flow approach
◦ WACC
V total market value of the firms
V= firms’ sources of funds
V= E+D+P 100%= E/V+D/V+P/V
◦ Cost of firms’ funds:
1. Equity (stocks) E RE
2. Debt (bonds) D RD
3
3. Preferred stocks P RP
Free cash flow approach
◦ WACC FORMULA
VS= VF – VD – VP
P0= Vs/ number shares outstanding
Free cash flow approach
Example:
At the beginning of 2001 Disney stocks were traded
at $20 - $25. The company’s
p y debt at the end of
Year 2000 was $66 million, no preferred stocks, and
4,148,002 shares of common shares of common
stock outstanding. Its year 2000 FCF was $4.8
million Disney experienced a 14% annual growth
million.
of FCF from 2000 to 2004 followed by a 7% annual rate
thereafter. WACC is estimated at 11% What is Disney’s stock
price
p at year
y 2001?
Free cash flow approach
Example:
2000 $4,800,000
2001 $4,800,000 (1,14)1 = $5,472,000
2002 $4 800 000 (1
$4,800,000 (1,14)
14)2 = $6,238,080
$6 238 080
2003 $4,800,000 (1,14)3 = $7,111,411
2004 $4,800,000 (1,14)4 = $8,107,009
2005 $5 472 000 (1
$5,472,000 07)1 =
(1,07) $8 674 499
$8,674,499
Free cash flow approach
Example:
Stable growth:
g
V2004 = $8,674,499 /0,11 – 0,07 = $216,862,475
V2001 = $216,862,475 / (1,11)4 = $142,854,029
V2001 = $142,854,029
$142 854 029
We estimate the value for the end of year 2000 to forecast the
g g price
beginning p of year
y 2001
Free cash flow approach
Example:
Variable growth:
V2001 = $5,472,000 / (1,15)1 = $4,929,730
V2001 = + $6,238,080
$6 238 080 / (1
(1,15)
15)2 = $5,062,966
$5 062 966
V2001 = + $7,111,411 / (1,15)3 = $ 5,199,802
V2001 = + $8,107,009 / (1,15)4 = $ 5,340,338
= $ 20,532,836
W i
We estimate h value
the l ffor the
h end
d off year 2000 to fforecast the
h
beginning price of year 2001
Free cash flow approach
We estimated d the
h value
l ffor the
h end d off year 2000 to
forecast the beginning price of year 2001, we got:
$23,48. Actual trading range $20 to $25.