Cash Flows to Stockholders
Chapter 7
Equity Markets and Stock
Valuation
• If you buy a share of stock, you can
receive cash in two ways
– The company pays dividends
– You sell your shares either to another investor
in the market or back to the company
• As with bonds, the price of the stock is the
present value of these expected cash
flows
Asset Pricing
Estimating Dividends
• Constant dividend
– The firm will pay a constant dividend forever
– This is like preferred stock
– The price is computed using the perpetuity
formula
• The price of an asset is the present value
of all future cash flows
• Constant dividend growth
– The firm will increase the dividend by a constant
percent every period
• Supernormal growth
– Dividend growth is not consistent initially, but
settles down to constant growth eventually
Zero Growth
• If dividends are expected at regular
intervals forever, then this is like preferred
stock and is valued as a perpetuity
• P0 = D / R
Dividend Growth Model
• Dividends are expected to grow at a
constant percent per period.
– P0 = D1 /(1+R) + D2 /(1+R)2 + D3 /(1+R)3 + …
– P0 = D0(1+g)/(1+R) + D0(1+g)2/(1+R)2 +
D0(1+g)3/(1+R)3 + …
• Rewritten:
P0 =
D 0 (1 + g)
D
= 1
R-g
R-g
1
Features of Common Stock
•
•
•
•
Voting Rights
Proxy voting
Classes of stock
Other Rights
– Share proportionally in declared dividends
– Share proportionally in remaining assets during
liquidation
– Preemptive right – first shot at new stock issue to
maintain proportional ownership if desired
Dividend Characteristics
• Dividends are not a liability of the firm until a
dividend has been declared by the Board
• Consequently, a firm cannot go bankrupt for not
declaring dividends
• Dividends and Taxes
– Dividend payments are not considered a
business expense; therefore, they are not taxdeductible
– Dividends received by individuals have
historically been taxed as ordinary income
– Dividends received by corporations have a
minimum 70% exclusion from taxable income
Features of Preferred Stock
• Dividends
– Stated dividend that must be paid before
dividends can be paid to common stockholders
– Dividends are not a liability of the firm and
preferred dividends can be deferred indefinitely
– Most preferred dividends are cumulative – any
missed preferred dividends have to be paid
before common dividends can be paid
• Preferred stock does not generally carry
voting rights
Stock Market
• Dealers vs. Brokers
• New York Stock Exchange (NYSE)
– Members
– Operations
– Floor activity
• NASDAQ
– Not a physical exchange, but a computerbased quotation system
– Large portion of technology stocks
2