Unisa Study Notes



Study unit 6STOCK VALUATIONWhat differentiates between debt and equity capitalThe term capital denotes the long-term funds of a firm. All items on the right-hand side of the firm’s balance sheet, excluding current liabilities, are sources of capital.Debt capital includes all long-term borrowing incurred by a firm, including bonds.Equity capital consists of long-term funds provided by the firm’s owners, the stockholders. A firm can obtain equity capital either internally, by retaining earnings rather than paying them out as dividends to its stockholders, or externally, by selling common or preferred stock.Voice in ManagementUnlike creditors, holders of equity capital are owners of the firm. Holders of common stock have voting rights that permit them to select the firm’s directors and to vote on special issues.Claims on income and assetsHolders of equity have claims on both income and assets that are secondary to the claims of creditors. Their claims on income cannot be paid until the claims of all creditors have been satisfied.The equity holder’s claims on assets also are secondary to the claims of creditors. If the firm fails, its assets are sold, and the proceeds are distributed in this order:Employees and customersThe governmentCreditors andEquity holdersMaturityUnlike debt, equity capital is a permanent form of financing for the firm. It does not “mature” so repayment is not required.Tax TreatmentInterest payments to debt-holders are treated as tax-deductible expenses by the issuing firm, whereas dividend payments to a firm’s common and preferred stock-holders are not tax-deductible.Understand the concept of market efficiency and basic ordinary share valuation using zero growth, constant growth and variable growth modelsCOMMON STOCK VALUATIONCommon stockholders expect to be rewarded through periodic cash dividends and an increasing – or at least non-declining – share value.Market EfficiencyActive markets such as the New York Stock Exchange are efficient – they are made up of many rational investors who react quickly and objectively to new information. The efficiency-market hypothesis (EMH), which is the basic theory describing the behaviour of such a “perfect” market, specifically states that:Securities are typically in equilibrium, which means that they are fairly priced and that their expected returns equal their required returns.At any point in time, security prices fully reflect all public information available about the firm and its securities, and these prices react swiftly to new information.Because stocks are fully and fairly priced, investors need not waste their time trying to find and capitalise on mispriced securities.The basic ordinary share valuation formulaThe value of a share of common stock is equal to the present value of all future cash flows (dividends) that is expected to provide over an infinite time horizon.Equation:P0=D11+r1+D21+r2+D31+r3+?+D∞1+r∞WhereP0= value of ordinary shareDt= per-share dividend expected at the end of year tr= required return on common stockZero-Growth ModelThe zero dividend growth model assumes that the share (stock) will pay the same dividend each year, year after year.Equation:P0=DrConstant-Growth ModelThe constant dividend growth model assumes that the share (stock) will pay dividends that grow at a constant rate each year—year after year forever.For this you need to use two equations depending on whether you are given an expected Dividend or the Past Dividend (the just paid dividend).Because the Constant-Growth formula works with the expected dividend if you are only given a “just paid dividend” you need to find the expected dividend using the following formula:Formula: D1= D01+gAfter this step they you are ready to substitute in the formula below:Formula:P0=D1r-gWhere:g= is the growth rateD1= expected dividendr= required rate of returnD0= ex-dividend (the just paid dividend)Variable-Growth ModelAllows for a change in the dividend growth rate. To determine the value of a share of stock in the case of variable growth, we use a four-step procedure:Assume ABC Corporation currently pays a dividend of R0.50 per share. You have estimated that the company’s dividend will grow at a rate of 15 per cent per year for the next three years. After that, the dividend will grow at a constant rate of 6 per cent. The required rate of return is 12 per cent.Calculate the expected future dividends using the growth rate of 15 per cent.1234YearDoFVIF 0.15,tFV(2) x (3)1501.15057.52501.32366.153501.52176.05Calculate the sum of the present values of expected future dividends using the required rate of return of 12 per cent.123DtFVIF 0.12,tFV(1) x (2)57.50.89351.3566.150.79752.7276.070.71254.22Sum of PVs is 158.22. This yields the value of 158 cents.Calculate the value of the share for the constant growth period from year 4 onwards. Note we use the growth rate of 6 per cent and not 15 per cent.D4 = D3 x (1+g) = 76.05 x (1+0.06)= 76.05 x 1.06= 80.61 centsUsing the formulaP=D4r-gP=80.610.12-0.06P=1.336 centsPV of 1,336 = 1,336 X PVIF0.12, 3= 1,336 X 0.712= 951,232= 951 centsAdd the PVs of the two growth periods.P0 = 158 + 951= 1, 109 cents= R11.09Step 1:Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 through N. This step require adjusting the most recent dividend, D0, using the initial growth rate, g1, to calculate the dividend amount for each year. Therefore, for the first N years,Step 2: Find the present value of the dividends expected during the initial growth period. Using the notation presented earlier, we can give this value asStep 3: Find the value of the stock at the end of the initial growth period, PN=(DN+1)/Ks-g2), which is the present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth rate, g2. This value is found by applying the constant-growth model to the dividends expected from year N +1 to infinity. The present value of PN would represent the value today of all dividends that are expected to be received from year N + 1 to infinity. This value can be represented byStep 4: Add the present value components found in Step 2 and 3 to find the value of the stock, P0.Discuss the free cash flow valuation model and the book value, liquidation value and price/earnings (P/E) multiple approachesFree Cash Flow Valuation ModelA firm’s value can be estimated by using its projected free cash flows (FCFs). This approach is appealing when one is valuing firms that have no dividend history or are start-ups or when one is valuing an operating unit or division of a larger public company.The free cash flow valuation model estimates the value of the entire company by finding the present value of its expected free cash flows discounted at its weighted average cost of capital, which is expected average future cost of fund over the long run.Because the value of the entire company, VC, is the market value of the entire enterprise (that is, of all assets), to find common stock value, VS, we must subtract the market value of all of the firm’s debt, VD, and the market value of preferred stock, VP, from VC.Equation:VS = VC – VD – VP Other Approaches to Common Stock ValuationBook ValueBook value per share is simply the amount per share of common stock that would be received if all of the firm’s assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders.Liquidation ValueLiquidation value per share is the actual amount per share of common stock that would be received if all of the firm’s assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money were divided among the common stockholders.Price/Earnings (P/E) MultiplesThe price/earnings (P/E) ratio reflects the amount investors are willing to pay for each dollar of earnings. The average P/E ratio in a particular industry can be used as the guide to a firm’s value – if it is assumed that investors value the earnings of that firm in the same way they do the “average” firm in the industry. The price/earnings multiple approach is a popular technique used to estimate the firm’s share value; it is calculated by multiplying the firm’s expected earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry.Explain the relationships among financial decisions, return, risk and the enterprise’s value.Decision Making and Common Stock ValueChanges in Expected ReturnAssuming that economic conditions remain stable, any management action that would cause current and prospective stockholders to raise their dividend expectations should increase firm’s value.Changes in RiskAlthough r, is defined as the required return, we know that it is directly related to the non-diversifiable risk, which can be measured by beta.Any action taken by the financial manager that increases risk (beta) will also increase the required return. With everything constant, an increase in the required return, r, will reduce share value, P0. Likewise, a decrease in the required return will increase share value. Thus any action of the financial manager that increases risk contributes to a reduction in value, and any action that decreases risk contributes to increase in bined EffectA financial decision rarely affects return and risk independently; most decisions affect both factors. In terms of the measures presented, with an increase in risk (b), one would expect an increase in return (D1 or g, or both), assuming that RF and km remain unchanged. ................
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