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Bond and Stock Valuation

Peachtree Securities,
Inc. (B-2)

What we need to know


Common Stock
A security that represents ownership in a corporation.
Holders exercise control by electing a board of directors
Common stockholders are on the bottom of the priority ladder for
ownership structure

Preferred Stock
A class of ownership in a corporation that has a higher claim on its assets
and earnings than common stock.
Shares do not usually carry voting rights
Dividends are paid to preferred stock before dividends are paid to common
stock
Combines features on debt

Constant Growth Model


Used to find the value of a constant growth stock
Also known as the Gordon Growth Model

What we need to know


Expected Rate of Return
The rate of return expected to be realized from an investment; the
weighted average of the probability distribution of the possible results

Effective Annual Return


The annual rate of interest actually being earned
The rate that would produce the same ending (future)
value if annual compounding had been used.

What we need to know


Expected Rate of Return, k s
The rate of return on a common stock that a shareholder
expects to receive in the future

Dividend Yield, D1/P0


The expected dividend divided by the current price of a share
of stock

Dividend Growth Rate, g


The expected rate of growth in dividends per share

Capital Gains Yield,


The expected rate of growth in dividends per share

6. TECO has $54,956,000 of


preferred stock outstanding
a. Supposed its Series A, which has a $100 par
value and pays a $4.32 percent cumulative
dividend currently sells for $48.00 per share.
What is its nominal expected rate of return? Its
effective annual rate of return?
(Hint: Remember that dividends are paid quarterly. Also, assume
that Expected
this issueRate
is perpetual.
Nominal
of Return
Effective Rate of Return
= (Par Value*Cumulative
Div/Current Price
= (100*4.32%)/$48
= 0.09 or 9.0%

= 1.09308 1
= 0.09308 or 9.31%

6. TECO has $54,956,000 of


preferred stock outstanding
b. Supposed its Series F, with a $100 par value and a $9.75
percent cumulative dividend has a mandatory sinking fund
provision. 60,000 of the 300,000 total shares outstanding
must be redeemed annually at par beginning at the end of
1993. If the nominal required rate of return is 8%, what is the
current (January 1, 1993) value per share?

Sinking Fund Provision


A provision in a bond contract that requires the issuer to retire a
portion of the bond issue each year.
Used to buy back a certain percentage of the bond issue each year

6. TECO has $54,956,000 of


preferred stock outstanding
b. Supposed its Series F, with a $100 par value and a $9.75
percent cumulative dividend has a mandatory sinking fund
provision. 60,000 of the 300,000 total shares outstanding
must be redeemed annually at par beginning at the end of
1993. If the nominal required rate of return is 8%, what is the
current (January 1, 1993) value per share?

What we need to know


Expected Total Return, ks = D1/P0 + [(P1-P0)/P0]
The sum of expected dividend yield and the expected capital
gains yield
For a constant growth firm, expected capital gains yield and
expected dividend yield are constant

Expected Rate of Return, ks = D1/P0 + g


The expected rate of return on a constant growth stock

7. Now consider TECOs common stock. Value Line


estimates TECOs 5-year dividend growth rate to be
6.0% (See Figure 1 in Case 2). Assume that TECOs
stock traded on January 1, 1992 for $22.26. Assume for
now that the 6.0% growth rate is expected to continue
indefinitely.

a. What was TECOs expected rate of return at the


beginning of 1992?
(Hint: Value Line estimated D1 to be $1.80 at the start of 1992. See
Figure 1 in Case 2).

Given:
D1 = $1.80
g = 6%
t = 5 yrs (1992-1997)

Expected Rate of Return


ks = Dividend Yield + Growth
Rate
= D1/P0 + g
= $1.80/$22.26 + 0.06
= 0.08086 + 0.06
= 0.14086 or 14.09%

7. Now consider TECOs common stock. Value Line


estimates TECOs 5-year dividend growth rate to be
6.0% (See Figure 1 in Case 2). Assume that TECOs
stock traded on January 1, 1992 for $22.26. Assume for
now that the 6.0% growth rate is expected to continue
indefinitely.

b. What was the expected dividend yield and


expected capital gains yield on January 1, 1992?
Expected Dividend Yield
= D1/P0
= $1.80/$22.26
= 0.08086 or 8.09%

Given:

Expected Capital Gains Yield


= (P1-P0)/P0
= ($22.26*1.06 + $22.26)/
$22.26
= 0.06 or 6%

The expected capital gains


yield is 6.00% same as the
growth
rate
since
the
company is assumed to have
6% dividend growth rate
indefinitely.

D1 = $1.80
g = 6%
t = 5 yrs (1992-1997)

7. Now consider TECOs common stock. Value Line


estimates TECOs 5-year dividend growth rate to be
6.0% (See Figure 1 in Case 2). Assume that TECOs
stock traded on January 1, 1992 for $22.26. Assume for
now that the 6.0% growth rate is expected to continue
indefinitely.

c. What is the relationship between dividend yield


and capital gains yield over time under constant
growth assumptions?
Year, t

Growth
rate, g

Stock
Price, Pt

0
1
2
3
4
5

6.00%
6.00%
6.00%
6.00%
6.00%
6.00%

$ 21.00
$ 22.26
$ 23.60
$ 25.01
$ 26.51
$ 28.10

Dividend, Dividend
Dt
Yield
$
$
$
$
$
$

1.70
1.80
1.91
2.02
2.14
2.27

8.09%
8.09%
8.09%
8.09%
8.09%
8.09%

Capital
Gains
Yield
6.00%
6.00%
6.00%
6.00%
6.00%
6.00%

Dt
(P1-P0)
Notes:
Pt
P0
Dividend yield and capital gains yield are directly
correlated
and remains constant under the constant growth
assumptions.
= Previous stock = Previous div
price * (1+g)
amount * (1+g)

7. Now consider TECOs common stock. Value Line


estimates TECOs 5-year dividend growth rate to be
6.0% (See Figure 1 in Case 2). Assume that TECOs
stock traded on January 1, 1992 for $22.26. Assume for
now that the 6.0% growth rate is expected to continue
indefinitely.

d. What conditions must hold to use the constant


growth (Gordon) model? Do many real world
stocks satisfy the constant growth assumptions?
The dividend is expected to grow forever at a constant rate, g
The stock price is expected to grow at this same rate
The expected dividend yield is a constant
The expected capital gains yield is also a constant, and it equal to g
The expected total rate of return, k s, is equal to the expected dividend
yield plus the expected growth rate: k s = dividend yield + g

Earnings growth results from a number of factors including (1) inflation, (2) the
amount of earnings the company retains and reinvests and the (3) rate of return the
company earns on its equity (ROE). Inflation might vary during different periods,
regulations and economic policies might affect the direction and profitability of
businesses and organizational strategy and corporate events might affect investors
perception of the company affecting its price value. The Gordon Constant growth
model is effective for companies with mature and stable history of growth.

What we need to know


Total Company (Corporate Value) Model
A valuation model used as an alternative to the dividend growth model to
determine the value of a firm, especially one that does not pay dividends or is
privately held.
Discounts a firms free cash flows at the WACC to determine its value.
Vcompany = PV of expected future free cash flows
=
FCF1
+
FCF1
++
FCF
.
(1 + WACC)1 (1 + WACC)2
(1 + WACC)

Free Cash Flows


Cash generated before making any payments to common or preferred
stockholders or to bond holders; Cash flow available to all investors
Discounted at the companys weighted average cost of debt, preferred
stock and common stock (WACC)
FCF = NOPAT Net new investment in operating capital

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

a. What was the value of TECO stock on January 1,


1992, if the required rate of return is 13.5%?

Given:
g (yr 1-5) = 6% t = 10
g (6 onwards) = 7.5%

What we need to know


Equilibrium
The condition under which the expected return on a security is just equal to
its required return
price is stable
Conditions:
1. A stocks expected rate of return as seen by the marginal investor must
equal its required rate of return; k hat = k
2. The actual market prices of the stock must equal its intrinsic value as
estimated by the marginal investor; P 0 hat = P0

Free Cash Flows


Cash generated before making any payments to common or preferred
stockholders or to bond holders; Cash flow available to all investors
Discounted at the companys weighted average cost of debt, preferred
stock and common stock (WACC)
FCF = NOPAT Net new investment in operating capital

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

b. What is the expected stock price at the end of


1992 assuming that the stock is in equilibrium?

If the stock is in equilibrium, the required rate of return must


equal the expected rate of return.

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

c. What is the expected dividend yield, capital


gains yield, and total return for 1992?
Capital Gains Yield
Expected Dividend
= (P1 -P0)/P0
Yield
= ($30.62 - $28.56)/
= D1/P0
$28.56
= $1.80/28.56
= 0.07198 or 7.20%
= 0.06303 or 6.30%
Total Rate of Return
= EDY + ECGY
= 6.30% + 7.20%
= 13.50%

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

d. Suppose TECOs dividend was expected to remain


constant at $1.80 for the next 5 years and then grow at
a constant 6% rate. If the required rate of return is
13.5%, would TECOs stock value be higher or lower
than your answer in Part A? if you are using the Lotus
model for the case, calculate the dividend yield, capital
gains yield, and total yield from 1992 through 1996.

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

The value of
share became
$19.76 which
is lower than
the $28.56
provided in A.

If the dividend remain constant at $1.8 per share,


TECOs expected stock value will fall by $8.8 per
share. Comparing to the initial trading price of

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).

e. TECOs stock price was $22.26 at the beginning of 1992.


Using the growth rates given in the introduction to this
question, what is the stocks expected rate of return?

8. Suppose you believe that TECOs 6.0% dividend


growth rate will only hold for 5 years. After that, the
growth rate will return to TECOs historical 10-year
average of 7.5%. Note that D6 = D5 x 0.075 (again, see
Figure 1 in Case 2).
f. Refer back to Figure 1 in Case 2. Look at the % Earned
Common Equity estimated for 1995 through 1997 and at
the projected earnings and dividends per share for the same
period. Could those figures be used to develop an estimated
long-run sustainable growth rate? Does this figure support
the 7.5% growth rate given in the problem? (Hint: Think of the
formula g = br = (retention ratio)(ROE).)

9. Common stocks are usually valued assuming annual


dividends even though dividend are actually paid
quarterly. This is because stream is so uncertain that
the use of a quarterly model is not warranted.

The quarterly constant growth valuation model is:

Where P0 is the stocks value and Dqi is the dividend in


Quarter i. Note that this model assumes that dividend
growth occurs once every year rather than at every quarter.
Assume that TECOs next four quarterly dividends are
$1.80/4 = $0.45 each; that k, the annual required rate of
return, is 13.5% and that g is a constant 6.0%. What is
TECOs value according to the quarterly model

9. Common stocks are usually valued assuming annual


dividends even though dividend are actually paid
quarterly. This is because stream is so uncertain that
the use of a quarterly model is not warranted.

The quarterly constant growth valuation model is:

Given:
D1 = $1.80;
Dqi = $0.45
k = 13.5%
g = 6%

Quarte
r

1
2
3
4

Divq

$
$
0.45
0.75
$
$
0.45
0.50
$
$
0.45
0.25
$
$
0.45
Total Annual
CF
k-g
=

PVs
Dqi(1+k)i

13.50%

$ 0.4948

13.50%

$ 0.4794

13.50%

$ 0.4645

13.50%

$ 0.4500

$ 1.8887

13.5% - 6%

7.5%