- Describe briefly the legal rights and privileges of common stockholders.
Common shareholders ownership is considered to be residual. That implies that common shareholders can claim firm’s earning only after those of government, debt holders, and preferred shareholders have been met. They are considered to be a true owner of the company or the corporation. By virtue of being the true owners, they possess dividend rights, assets rights, voting rights, and pre-emptive rights.
Going into further details , the common shareholders have the legal right to elect it board’s directors. The board in turn decides and elects who all run the business. In small organizations, the shareholder with maximum amount of shares acts as a President and Chairperson of the board. In contrast, in large publicly traded companies, managers do keep certain amount of stock. Typically their holdings are insufficient to give them management control. In such a situation, if they are not effective in delivering results, they can be removed by stakeholders.
The common shareholders have, what is called, the pre-emptive right. This allows them to purchase any additional shares sold by the firm. This allows them to retain control and prevents transfer of control from new to old stakeholders.
- Question B
- Write a formula that can be used to value any stock, regardless of its dividend pattern.
The General Dividend Valuation Model can be applied regardless whether the stream of dividends over the period of time fluctuate or remain constant, increasing or decreasing.
Pn= t=n+1∞Dt(1+ Ke)t
Here the values of the shares at the end of nth period would be Pn. Therefore, the value of a firm’s common shares is equal to the discounted present value of the expected future dividend stream.
- What is a constant growth stock? How are constant growth stocks valued?
The constant growth valuation model assumes that a firm’s earnings, dividends and share price are expected to grow at a constant rate, g, into the future. Hence, to apply this model to a specific common share, it is necessary to estimate the expected future growth rate, g.
Assuming that the required rate of return, ke is greater than the dividend growth rate, g, the following would be the simplified equation of the common share valuation model
P0= D1ke -g
Where D1 is the dividend expected to be received one year from the start. The required rate of return is ke.
- What happens if a company has a constant g that exceeds its ks? Will many stocks have expected g>ks in the short run (that is, for the next few years)? In the long run (that is, forever)?
Then the general equation will hold true, which is
P0= t=1∞D01+gt1+ ket
- Assume that Bon Temps has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, and the required rate of return on the market is 12 percent. What is the required rate of return on the firm’s stock?
The formula to be applied is kj= rf+ βjrm= rf, where is required rate of return on the firm’s stock, rf is risk-free rate, rm is required market return, and systemic risk is βj.
So, kj for Bon Temps would be = 7 + 1.2(12 – 7) = 13%.
- Assume that Bon Temps is a constant growth company whose last dividend (D0, which was paid yesterday) was $20 and whose dividend is expected to grow indefinitely at a 6 percent rate.
- What is the firm’s expected dividend stream over the next 3 years?
The equation would be
D3= D0 1+g3
Putting the values, the dividend stream is = 20 (1 + .06) + 20(1 + .06)2 + 20 (1 + .06)3
That will be the sum of 21.2 + 22.47 + 23.82 = 68.28
- What is the firm’s current stock price?
Going by the formula P0= D1ke-g
The current stock price would be 21.2/(.13 - .06) = $302.86
- What is the stock’s expected value 1 year from now?
Going by the formula P1= P01+ ke, the stock value after 1 year would be 302.86 (1.13) = $342.23
- What are the expected dividend yield, the capital gains yield, and the total return during the first year?
The dividend yield is D1P0 = 21.2/302.86 = 0.07 or 7%
- Now assume that the stock is currently selling at $30.29. What is the expected rate of return on the stock?
Using the formula ke= D1P0+g = 21.2/30.29 + .06 = .76
- What would the stock price be if its dividends were expected to have zero growth?
Using the formula P0= Dke , = 20/.76 = $26.31
- Now assume that Bon Temps is expected to experience supernormal growth of 30 percent for the next 3years, then to return to its long-run constant growth rate of 6 percent. What is the stock’s value under these conditions? What is its expected dividend yield and capital gains yield in Year 1? Year 4?
Dividend at the end of 1 year would be = 20 (1 + .3)/ (1 + .12) = 23.21, at the end of 2nd year = 20 (1 + .3)2 / (1 + .12)2 = 20.72, and at the end of 3rd year = 20 (1 + .3)3 / (1 + .12)3 = 18.50. The total of which is $62.43.
The value at the end of year 3 would be P3= D4ke-g2 = 20 (1 + .3)3 * (1 + .06) / (.12 - .06) = 776.27. Therefore, the total P0 of the stock would be 776.27 + 62.43 = $838.7
The Capital Gains yield in Year 1 is 30% and in Year 4 is 6%
The Dividend Yield at the end of Year 1 is 20 (1 + .3)/838.7 = 0.031, and at the end of Year 4 is 20 (1 + .3)3 / 776.27 = 0.056
- Suppose Bon Temps is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6 percent in the fourth year. What is the stock’s value now? What is the expected dividend yield and its capital gains yield in Year 1? Year 4?
The value at the end of Year 3 would be P0= Dke , 20/.12 = $166.67
The value at the end of year 4 would be P3= D4ke-g2 = 20 (1 + .06)/(.12-.06) = $353.34
So, the total value would be $520.
The Dividend Yield at the end of Year 1 is D/P0 = 20/166.67 = 0.12, and at the end of Year 4 is D(1 + g)/P3 = 20 ( 1 + .06)/353.34 = 0.06.
The Capital Gains Yield at the end of Year 1 is 0%, and in the Year 4 is 6%.
- Finally, assume that Bon Temps’ earnings and dividends are expected to decline by a constant 6 percent per year, that is, g= -6%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would be the dividend yield and capital gains yield in each year?
Assuming that Bon Temps’ earnings and dividends are expected to decline by 6%, people will still be interested in buying it as it would be a good future investment.
Its P0 would be = 20 (1 - .06) / (.12 + .06) = $117.78
Its Dividend Yield will be 20 (.94)/117.78 = 0.16%
Its Capital Gains Yield will be -6%.
- What does market equilibrium mean?
Market equilibrium exists whenever there is no tendency for the price of the asset to move higher or lower . At this point, the expected rate of return on the asset is equal to the marginal investor’s required rate of return.
- If equilibrium does not exist, how will it be established?
“In terms of supply, higher prices encourage supply, given the supplier's expectation of higher revenue and profits, and hence higher prices reduce the opportunity cost of supplying more. Lower prices discourage supply because of the increased opportunity cost of supplying more. The opportunity cost of supply relates to the possible alternative of the factors of production.”.
- What is the Efficient Markets Hypothesis, what are its three forms, and what are its implications?
According to the Efficient Markets Hypothesis , “at any given point of time and in the liquid market, security prices fully reflect all available information. The EMH exists in various degrees: weak, semi-strong and strong, which addresses the inclusion on non-public information in market prices”. When the markets are inefficient and current prices reflect all the information, any attempt to outperform the market is in essence a game of chance rather than that of skill.
- Phyfe Company recently issues preferred stock. It pays an annual dividend of $5, and the issue price was $50 per share. What is the expected return to an investor on this preferred stock?
In the preferred stocks, the dividends don’t increase. So, the expected return or Dividend Yield will be 5/50 = .1%
Bibliography
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Cyr, D. et al., 2004. Common Shares: Characteristics and Valuation. In: V. V. &. R. Kitowski, ed. Contemporary Financial Management. Canada: Thomson Nelson, pp. 225 - 226.
Economics Online, n.d. Market Equilibrium. [Online] Available at: http://www.economicsonline.co.uk/Competitive_markets/Market_equilibrium.html[Accessed 07 01 2014].
Ehrhardt, M. C. & Brigham, E. F., 2013. Valuation of Stocks and Corporations. In: Corporate Finance: A Focused Approach. 5 th ed. s.l.:South-Western College Pub, pp. 290 - 291.
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