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Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Copyright 2012 by The McGraw-Hill Companies, Inc.

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Principles of
CORPORATE FINANCE
Richard A Brealey Stewart C Myers
Franklin Allen Pitabas Mohanty
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Topics Covered

How Common Stocks Are Traded
How Common Stocks Are Valued
Estimating The Cost Of Equity Capital
The Link Between Stock Price and Earnings
per Share
Valuing a Business by Discounted Cash Flow
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Traded
Primary Market - Market for the sale of new
securities by corporations.

Secondary Market - Market in which
previously issued securities are traded
among investors.

Common Stock - Ownership shares in a
publicly held corporation.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Traded
Electronic Communication Networks ( ECN s) A
number of computer networks that connect
traders with each other.

Exchange-Traded Funds (ETFs) - portfolios of stocks
that can be bought or sold in a single trade.

SPDRs (Standard & Poors Depository Receipts or
spiders) ETFs, which are portfolios tracking
several Standard & Poors stock market indexes.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Book Value - Net worth of the firm according to the
balance sheet.
Dividend - Periodic cash distribution from the firm
to the shareholders.
P/E Ratio - Price per share divided by earnings per
share.
Market Value Balance Sheet - Financial statement
that uses market value of assets and liabilities.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
dividends) future d PV(expecte PV(stock)=
The value of any stock is the present value of its
future cash flows. This reflects the DCF formula.
Dividends represent the future cash flows of the
firm.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Expected Return - The percentage yield that an
investor forecasts from a specific investment over
a set period of time. Sometimes called the
market capitalization rate.
Expected Return = =
+
r
Div P P
P
1 1 0
0
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Example: If Fledgling Electronics is selling for Rs.100
per share today and is expected to sell for Rs.110
one year from now, what is the expected return if
the dividend one year from now is forecasted to
be Rs.5.00?
15 .
100
100 110 5
Return Expected =
+
=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
The price of any share of stock can be thought
of as the present value of the futures cash
flows. For a stock the future cash flows are
dividends and the ultimate sales price of the
stock.
r
P Div
P
+
+
= =
1
Price
1 1
0
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Example - continued: Fledgling Electronics price
can be thought of as follows.
100
15 . 1
110 5
Price
0
=
+
= = P
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Market Capitalization Rate can be estimated using
the perpetuity formula, given minor algebraic
manipulation. It is also called the Cost of Equity
Capital.



g
P
Div
r
g r
Div
P
+ = =

= =
0
1
1
0
Rate tion Capitaliza
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Dividend Discount Model - Computation of todays
stock price which states that share value equals
the present value of all expected future dividends.

P
Div
r
Div
r
Div P
r
H H
H
0
1
1
2
2
1 1 1
=
+
+
+
+ +
+
+ ( ) ( )
...
( )

H - Time horizon for your investment.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Modified formula

P
Div
r
Div
r
Div P
r
H H
H
0
1
1
2
2
1 1 1
=
+
+
+
+ +
+
+ ( ) ( )
...
( )
H
H
H
t
t
t
r
P
r
Div
P
) 1 ( ) 1 (
1
0
+
+
+
=

=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Example
Fledgling Electronics is forecasted to pay a Rs.5.00
dividend at the end of year one and a Rs.5.50 dividend at
the end of year two. At the end of the second year the
stock will be sold for Rs.121. If the discount rate is 15%,
what is the price of the stock?

00 . 100 .
) 15 . 1 (
121 50 . 5
) 15 . 1 (
00 . 5
2 1
Rs PV
PV
=
+
+
+
+
=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Another Example
Current forecasts are for XYZ Company to pay
dividends of Rs.3, Rs.3.24, and Rs.3.50 over the
next three years, respectively. At the end of three
years you anticipate selling your stock at a market
price of Rs.94.48. What is the price of the stock
given a 12% expected return?
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Another Example
Current forecasts are for XYZ Company to pay dividends of
Rs.3, Rs.3.24, and Rs.3.50 over the next three years,
respectively. At the end of three years you anticipate
selling your stock at a market price of Rs.94.48. What is
the price of the stock given a 12% expected return?
00 . 75 .
) 12 . 1 (
48 . 94 50 . 3
) 12 . 1 (
24 . 3
) 12 . 1 (
00 . 3
3 2 1
Rs PV
PV
=
+
+
+
+
+
+
=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
How Common Stocks Are Valued
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Dividend Yield The expected return on a stock
investment plus the expected growth in the
dividends. Similar to the capitalization rate.



g
P
Div
r
g r
Div
P
+ = =

= =
0
1
1
0
Yield Dividend
Price
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Example - Northwest Natural Gas stock was selling for $42.45
per share at the start of 2009. Dividend payments for the
next year were expected to be $1.68 a share. What is the
dividend yield, assuming no growth?



04 .
45 . 42
68 . 1
Yield Dividend
=
=
=
r
r
r
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Example - continued - Northwest Natural Gas stock was
selling for $42.45 per share at the start of 2009. Dividend
payments for the next year were expected to be $1.68 a
share. What is the dividend yield, assuming a growth rate
of 6.1%?



101 .
061 .
45 . 42
68 . 1
Yield Dividend
=
+ =
=
r
r
r
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Return Measurements



0
1
P
Div
Yield Dividend =
Share y Per Book Equit
EPS
Equity on Return
=
=
ROE
ROE
g
P
Div
r
g r
Div
P
+ =

=
0
1
1
0
Restated
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Dividend Growth Rate can also be derived from
applying the return on equity to the percentage
of earnings plowed back into operations.

g = return on equity X plowback ratio
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Valuing Non-Constant Growth
H
H
H
H
r
P
r
Div
r
Div
r
Div
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
g r
Div
P
H
H

=
+1
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Estimating the Cost of Equity Capital
Example Phoenix produces dividends in three consecutive
years of 0, .31, and .65, respectively. The dividend in year
four is estimated to be .67 and should grow in perpetuity
at 4%. Given a discount rate of 10%, what is the price of
the stock??



13 . 9
) 04 . 10 (.
67 .
) 1 . 1 (
1
) 1 . 1 (
65 .
) 1 . 1 (
31 .
) 1 . 1 (
0
3 3 2 1
=
(

+
+
+
+
+
+
+
= PV
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Price and Earnings Per Share
If a firm elects to pay a lower dividend, and
reinvest the funds, the stock price may increase
because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as
dividends
Plowback Ratio - Fraction of earnings retained by
the firm
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33
dividend next year, which represents 100%
of its earnings. This will provide investors
with a 15% expected return. Instead, we
decide to plowback 40% of the earnings at
the firms current return on equity of 25%.
What is the value of the stock before and
after the plowback decision?
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Price and Earnings Per Share
Example
Our company forecasts to pay a Rs.8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plowback 40% of the
earnings at the firms current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
56 . 55 .
15 .
33 . 8
0
Rs P = =
No Growth With Growth
00 . 100 .
10 . 15 .
00 . 5
10 . 40 . 25 .
0
Rs P
g
=

=
= =
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Price and Earnings Per Share
Example - continued
If the company did not plowback some earnings, the stock
price would remain at Rs.55.56. With the plowback, the
price rose to Rs.100.00.

The difference between these two numbers is called the
Present Value of Growth Opportunities (PVGO).
44 . 44 . 56 . 55 00 . 100 Rs PVGO = =
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Price and Earnings Per Share
Present Value of Growth Opportunities
(PVGO) - Net present value of a firms
future investments.

Sustainable Growth Rate - Steady rate at
which a firm can grow: plowback ratio X
return on equity.
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing a Business
Valuing a Business or Project
The value of a business or Project is usually
computed as the discounted value of FCF out to a
valuation horizon (H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing a Business
Valuing a Business or Project

H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
) 1 ( ) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+
+
+ +
+
+
+
=
PV (free cash flows) PV (horizon value)
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing a Business
Example
Given the cash flows for Concatenate Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value),
and the total value of the firm. r=10% and g= 6%
6 6 6 13 13 20 20 20 20 20 (%) growth .EPS
1.89 1.79 1.68 1.59 .23 - .20 - 1.39 - 1.15 - .96 - .80 - Flow Cash Free
1.89 1.78 1.68 1.59 3.04 2.69 3.46 2.88 2.40 2.00 Investment
3.78 3.57 3.36 3.18 2.81 2.49 2.07 1.73 1.44 1.20 Earnings
51 . 31 73 . 29 05 . 28 47 . 26 43 . 23 74 . 20 28 . 17 40 . 14 00 . 12 00 . 10 Value Asset
10 9 8 7 6 5 4 3 2 1
Year
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value), and the
total value of the firm. r=10% and g= 6%

( )
4 . 22
06 . 10 .
59 . 1
1.1
1
value) PV(horizon
6
=
|
.
|

\
|

=
( ) ( ) ( ) ( ) ( )
6 . 3
1 . 1
23 .
1 . 1
20 .
1 . 1
39 . 1
1 . 1
15 . 1
1 . 1
96 .
1.1
.80
- PV(FCF)
6 5 4 3 2
=
=
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Valuing a Business
Example - continued
Given the cash flows for Concatenator Manufacturing Division,
calculate the PV of near term cash flows, PV (horizon value), and the
total value of the firm. r=10% and g= 6%

Rs.18.8
22.4 -3.6
value) PV(horizon PV(FCF) s) PV(busines
=
+ =
+ =
Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Web Resources
Click to access web sites
Internet connection required
www.dividenddiscountmodel.com
www.valuepro.net
www.nyse.com
www.nasdaq.com
www.londonstockexchange.com
www.tse.or.jp
www.123world.com/stockexchanges
www.rba.co.uk
www.fibv.com

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