Cameron School of Business
UNIVERSITY OF NORTH CAROLINA WILMINGTON
An Introduction to Finance
and the Dividend Growth
Model
Edward Graham
Professor of Finance
Department of Economics and
Finance
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Continuing your Introduction to Finance
Recalling the Broad Introduction to Finance
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I.
The Three Primary Duties of the Financial Manager
II.
Stock Valuation Primer: The Dividend Growth Model
An Introduction to Finance
What is finance?
• Finance is the study of the art and the science of money
management; it is based on the Latin root finis,
meaning the end. In managing ours or our firm’s money,
we consider historical outcomes or “endings,”
and we propose future results as a function of decisions
made today. Those outcomes or results are
typically portrayed using financial statements.
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I.
The Three Primary Duties of the
Financial Manager
Whether managing monies for the home, or for the firm, our
duties are met with decisions framed by the same general
principles. These principles instruct us in making three main
types of decisions as we perform those three primary duties:
•The capital budgeting decision
•The capital structure decision
•The working capital decision
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The Capital Budgeting Decision
With the capital budgeting decision, the financial manager
decides where best to deploy monies long-term. The
purchase of a new delivery truck or a new warehouse
is a capital budgeting decision; the payment of a utility
bill is not.
With the making of this decision, we consider three features
of the cash flows deriving from the decision:
• The size of the cash flows
• The timing of the cash flows
• The risk of the cash flows
We review a couple examples of capital budgeting decisions.
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The Capital Structure Decision
With the capital structure decision, the financial manager decides
from where best to acquire monies long-term. The purchase of that
new delivery truck with cash or with a loan from GMAC or Ford
Motor Credit is a capital structure decision; the use of long-term
borrowing to fund a franchise purchase is another.
Perhaps most importantly, the decision to fund a firm’s growth with
equity - such as with funds invested by the firm’s founders, angel
investors, venture capitalists or public stock offerings – or debt, is
a critical capital structure choice. Two features of this choice bear
mentioning:
• The risk of the debt
• The loss of control and reduced potential cash flows to the
founders with an equity or stock sale
We expand our review with a few capital structure decisions.
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The Working Capital Decision
With the working capital decision, current assets and current
liabilities become the focus of the financial manager.
Such items as cash balances, accounts receivable, inventory levels
and short-term accruals (such as prepaid rent or utilities) are
included among the short-term assets that comprise one
component of working capital.
Also with the working capital decision, we concern ourselves with
short-term obligations such as accounts payable to vendors,
and other debt that is expected to be paid off within one year.
Net working capital is a meaningful outcome of the working capital
decision-making matrix. Net working capital is merely the
difference between current assets and current liabilities.
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II. Stock Valuation Primer: Dividend Growth Model
Recall the primary goal of making decisions towards the
maximization of shareholder wealth.
How do we know when we are doing that? We must first
understand stock value.
Here, we are introduced to the “idea” of stock valuation,
understanding that for the “pro’s,” this is a life-long
learning experience.
• Table 7.1 guides us.
• Section 7.2 provides some general definitions and
features of the domestic stock markets.
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The Dividend Growth Model (DGM) in Section 7.1
A great summary of the features of the DGM is given in Table 7.1
on page 203.
As well, assigned homework problems for all of chapter 7, and the
practice questions for chapter 7 from the web file “Chapter 6 – 8
Practice Questions,” are supportive.
•
First, the DGM in the simplest case:
Suppose a stock has a single cash flow (cf) in one year of
$20.00. What is the value of that stock?
Well, our chapter 4 stuff on valuing single cf’s tells us:
Stock Value = $20/(1 + r)^t, where r = 15% and t = 1
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The Dividend Growth Model (DGM) in Section 7.1
Stock Value = $20/(1 + r)^t, where r = 15% and t = 1
Kind of makes sense, if our required return or “r” is 15%, and
the cf in one year makes t equal to 1, we have:
Stock Value (Po) = 20/1.15 = 17.39. Where the “gain” from
buying the stock now for $17.39 to its value in a year of $20
(a gain of $2.61) gives us our 15% return of 2.61/17.39.
We get a 15% return by selling our stock in a year for $20,
having bought it for $17.39.
But, what if our time value of money (or required return, in
this case) is greater than 15%? Well, recalling V=I/R, our
classic valuation function, with a bigger R comes a smaller
V. Examples?
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The Dividend Growth Model (DGM) in Section 7.1
• Second, the DGM with constant and perpetual cf’s:
Assume now that our $20 “dividend” occurs every year –
our stock “pays” a $20 annual dividend. What is the
stock value now? Recalling work from chapter 5, for
valuing constant cash flows:
Value = cf/r, or as in Table 7.1, Po= D/R, where the
dividend is D or $20, and R is r - our discount rate of
15%, and Po = 20/.15 = $133.33.
Our 15% annual return is provided where R = D/Po or
15% = 20/133.33.
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The Dividend Growth Model (DGM) in Section 7.1
• Third, and as in part III of Table 7.1, what of the value of our
stock if its dividend or cf is growing at 10% per year?
Po = D1/(R – g), where D1 is the dividend one period hence,
R is our 15% required return as before, and g is 10%, our
assumed annual dividend growth rate in this example.
We find that D1 = D0(1 + g) = 20(1.1) = 22. R – g = .05 …
• So, Po = 22/.05 = 440.
And, P1 = D2/.05 = 22(1.1)/.05 = 24.2/.05 = 484
• Our overall return becomes R = D1/Po + g. (See the
algebra?)
R = a dividend yield plus a capital gains yield.
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The Dividend Growth Model (DGM) in Section 7.1
Our R, then, based on the algebra, is comprised of a
dividend yield and a capital gains yield:
Requiring a 15% return, we get it in two ways, from
dividends and from capital gains.
Our dividend is going to be $22 in this last example (D1),
and our capital gain is going to be P1 - Po, or $484
minus $440, or $44. Our total return becomes the sum
of these, or $22 plus $44 or $66, which is exactly 15%
of our original investment of $440. (D1 + [P1 – Po])/Po
is (22 + 44)/440 or 66/440 or 15%.
Pretty straightforward once you think about it! Use Table
7.1 to support your introduction to the DGM.
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The Dividend Growth Model (DGM) and Section 7.2
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•
Finally, remember that with the DGM we have been valuing common
stock, as described and discussed in your text in Section 7.2.
•
Common stock has certain ownership rights to the future cash flows of
a publicly traded corporation, and these rights are securitized and
traded on the Nasdaq or the NYSE. And, it is the value of those “traded
rights” or shares of common stock that we have been trying to estimate.
•
Bonds in chapter 6 were “easy.” The size and timing of the cash flows
with them, and the market’s “required return” (or yield to maturity) were
all published as the bonds were traded. But, with stocks, the size,
timing and duration of the cash flows are uncertain, and the market’s
required return is unknown, as well. So, we estimate the required
return, and the cash flows, and START to get a sense of the value with
the DGM.
•
It is just a START, but we must start somewhere!! Good luck!