Business Finance Exam 2 Notes (Chapter 7)

1. The cash flows from owning a share of stock come in the form of... 2. As the owner of shares of common stock in a cor- poration, you have various rights, including: 3. Voting in corporate elec- tions can be either: future dividends. the right to vote to elect corporate directors. 1. Cumulative 2. Straight 4. Most voting is done by... proxy. 5. Proxy battles... break out when competing sides try to gain enough votes to have their candidates for the board elected. Someone seeks after a bunch of investors' proxy votes so they can take control of the project 6. In addition to common stock, some corporations have issued... 7. Preferred stockholders must... preferred stock. be paid first, before common stockholders can receive anything. 8. Preferred stock has a... fixed dividend. 9. The two biggest stock mar- kets in the United States 10. Why does the value of a share of stock depend on dividends? NYSE NASDAQ The value of any investment depends on its cash flows; i.e., what investors will actually receive. The cash flows from a share of stock are the divi- dends. 11. A substantial percentage of the companies listed on the NYSE and the NAS- DAQ don't pay dividends, but investors are nonethe- less willing to buy shares in them. How is this possi- ble given your answer to the previous question? 12. Referring to the previous questions, under what cir- cumstances might a compa- ny choose not to pay divi- dends? 13. Under what two assump- tions can we use the divi- dend growth model present- ed in the chapter to deter- mine the value of a share of stock? Comment on the reasonableness of these as- sumptions. Investors believe the company will eventually start paying dividends (or be sold to another company). In general, companies that need the cash will often forgo dividends since dividends are a cash expense.Young, growing companies with profitable investment opportunities are one ex- ample; another example is a company in fi- nancial distress. This question is examined in depth in a later chapter. The general method for valuing a share of stock is to find the present value of all ex- pected future dividends. The dividend growth model presented in the text is only valid (i) if dividends are expected to occur forever; that is, the stock provides dividends in perpetuity, and (ii) if a constant growth rate of dividends occurs forever. A violation of the first assump- tion might be a company that is expected to cease operations and dissolve itself some fi- nite number of years from now. The stock of such a company would be valued by the meth- ods of this chapter by applying the general method of valuation. A violation of the second assumption might be a start-up firm that isn't currently paying any dividends, but is expected to eventually start making dividend payments some number of years from now. This stock would also be valued by the general dividend valuation method of this chapter. 14. Suppose a company has a preferred stock issue and a common stock issue. Both The common stock probably has a higher price because the dividend can grow, where- as it is fixed on the preferred. However, the have just paid a $2 dividend. preferred is less risky because of the dividend Which do you think will have a higher price, a share of the preferred or a share of the common? 15. Based on the dividend growth model, what are the two components of the total return on a share of stock? Which do you think is typi- cally larger? 16. In the context of the divi- dend growth model, is it true that the growth rate in div- idends and the growth rate in the price of the stock are identical? 17. Is it possible for a compa- ny to pay dividends when it has a negative net income for the year? Could this hap- pen for longer periods? and liquidation preference, so it is possible the preferred could be worth more, depending on the circumstances. The two components are the dividend yield and the capital gains yield. For most compa- nies, the capital gains yield is larger. This is easy to see for companies that pay no divi- dends. For companies that do pay dividends, the dividend yields are rarely over five percent and are often much less. The dividend growth model makes the implicit assumption that the stock price will grow at the same constant rate as the dividend. What this means is that if the cash flows on an in- vestment grow at a constant rate through time, the value of that investment grows at the same rate as the cash flows. For a particular year, this can (and often does) happen. Going back to the cash flow identity, the dividend payments depend on operating cash flow, capital spending, the change in net working capital, and the cash flow to creditors. The firm could have positive operating cash flow with negative earnings, sell fixed assets, reduce net working capital, or raise cash from creditors in order to pay dividends. While this is possible in the short term, as a practical mat- ter over the longer term, the company would probably need to have a positive net income (at least on average) in order to maintain a dividend. 18. Is it unfair or unethical for corporations to create classes of stock with un- equal voting rights? 19. Some companies, such as Google, have created class- es of stock with little or no voting rights at all. Why would investors buy such stock? 20. Evaluate the following state- ment: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the ex- pense of long-term profits. 21. In the constant dividend growth model, what is the highest reasonable growth rate for a stock's dividend? 22. In the chapter, we men- tioned that many companies have been under pressure to declassify their boards of directors. Why would in- vestors want a board to be declassified? What are the advantages of a classified board? It wouldn't seem to be. Investors who don't like the voting features of a particular class of stock are under no obligation to buy it. Investors buy such stock because they want it, recognizing that the shares have no voting power. Presumably, investors pay less for such shares than they would otherwise. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false. A reasonable limit for the growth rate is the growth rate of the economy, which in the U.S. has historically been about 3 to 3.5 percent (after accounting for inflation). As we will see in a later chapter, inflation has historically av- eraged about 3 percent, so 6 to 6.5 percent (before accounting for inflation) would be a reasonable limit. In a declassified board, every board seat is up for election every year. This structure allows investors to vote out a director (and even the entire board) much more quickly if investors are dissatisfied. However, this structure also makes it more difficult to fight off a hostile takeover bid. In contrast, a classified board can more effectively negotiate on behalf of stockholders, perhaps securing better terms in a deal. Classified boards are also important for institutional memory. If an entire board were 23. What are the difficulties in using the PE ratio to value stock? 24. If you own a share of stock, what are the two ways you can receive cash? 25. As with bonds, the price of the stock is the... 26. One period 27. Two period 28. Three period 29. The price of the stock being sold is really just the... 30. 3 special cases of estimat- ing dividends voted out in a single year, there would be no board members available to evaluate the company's direction with regards to previous decisions. The major difficulty in using price ratio analysis is determining the correct benchmark PE ratio. In a previous chapter, we showed how the sustainable growth rate is determined, and in a future chapter we will discuss the required re- turn. Although not exact measures, the growth rate and required return have a solid economic basis. With the PE ratio, like any other ratio, it is difficult to determine what the ratio should be. Since a small difference in the PE ratio can have a significant effect on the calculated stock price, it is easy to arrive at an incorrect valuation. 1. The company pays dividends 2. You sell shares, either to another investor in the market or back to the company present value of these expected cash flows Dividends -- cash income Selling -- capital gains present value of all expected future dividends Stock value = PV of dividends 31. Constant dividend/Zero growth 1. Constant dividend/Zero growth 2. Constant growth 3. Supernormal growth Firm will pay a constant dividend forever Dividends expected at regular intervals forever (perpetuity) Like preferred stock Price is computed using the perpetuity formula 32. Perpetuity Dividends expected at regular intervals forever P0 = D / R 33. Zero growth example: Suppose stock is expect- ed to pay a $2.00 dividend every year and the required return is 10%. What is the price? P0 = $2/.10 = $20 34. Constant dividend growth Firm will increase the divided by a constant percent every period One whose dividends are expected to grow forever at a constant rate, g. 35. Constant growth model con- ditions 1. Dividend expected to grow at g forever 2. Stock price expected to grow at g forever 3. Expected dividend yield is constant 4. Expected capital gains yield is constant and equal to g 5. Expected total return, R, must be g 6. Expected total return (R): = expected dividend yield (DY) + expected growth rate (g) = dividend yield + g 36. The price is based on look- ing at the following year's... dividend. 37. D0 Dividend JUST PAID 38. D1 to Dt Expected dividends 39. If the dividend price (g) grows, the stock price... 40. If the required return (R) goes down, the stock price... also grows. also goes down 41. Nonconstant growth We have to find the PV of ALL expected future dividends 42. Supernormal growth Dividend growth is not consistent initially, but settles down to constant growth eventually 43. Stocks that don't pay divi- dends (or have erratic div- idend growth rates) can be valued using the... price-earnings (PE) ratio and/or the price-sales ratio 44. In P0 = D1 / (r-g), cannot g; be bigger than . r 45. Dividend yield D1 / P0 46. Required return equation r = (D1 / P0) + g 47. Requied return can only come from 2 components: 1. Dividend yield 2. Capital gains yield 48. Who elects directors? Stockholders 49. How many assumed seats to 3 fill/being elected into? 50. Straight voting If there are 1,000,000 available shares, you would need 500,001 to win (Half plus one) 51. Cumulative voting If 4 people have 250,001 shares, 250,000, 250,000, and 249,999, only those top three would have ownership Have to break any four way tie 52. Boards are often... staggered, or "classified" 53. Classes of stock 1. Founders' shares 2. Class A and Class B shares 54. Are companies required to pay out dividends? 55. Are dividends tax de- ductible for a firm? 56. Preferred stock is like a hy- brid between... No. Dividends are not an obligation for a com- pany...whether a company issues dividends or not can change at any time No. a stock and a bond. 57. Rights of common stock - Share proportionally in declared dividends - Share proportionally in remaining assets dur- ing liquidation - Preemptive right 58. Preemptive right Right of first refusal to buy new stock issue to maintain proportional ownership if desired 59. Dividends are not a liabili- ty of the firm until declared by... 60. Dividends are taxed as for individuals. the Board of Directors. ordinary income 61. Dividends received by cor- porations have a minimum exclusion from taxable income. 62. Preferred stock must be paid before... 63. Are dividends of preferred stock a liability of a firm? 64. Dividends for preferred stock can be deferred... 65. Most preferred dividends are... 70% dividends can be paid out to common stock- holders No. indefinitely. cumulative. 66. M_ ihssaevde tporebfeerpreadiddbiveidfoernedcsommon dividends ca 67. Does preferred stock gener- ally carry voting rights? No. 68. Types of stock markets 1. Primary: new-issue market (the company gets the money) 2. Secondary: existing shares traded among investors 69. Dealer Maintains an inventory Ready to buy or sell at any time Like a used car dealer 70. Broker Brings buyers and sellers together Doesn't actually own any inventory Like a real estate agent/broker 71. New York Stock Exchange Members historically by a trading license ("own a seat") Designated market makers Floor brokers 72. Operational goal of NYSE Attract order flow 73. NASDAQ Computer-based quotation system Multiple market makers Electronic Communications Networks Large portion of technology stocks 74. 3 levels of information in the NASDAQ Level 1: median quotes, registered represen- tatives Level 2: view quotes, brokers and dealers Level 3: view and update quotes, dealers only 75. ECNs Electronic Communications Networks Provide direct trading among investors 76. What information is provid- ed in the stock quote?