Class 2
Valuation of Cash Flow
Streams
Common Stock
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Stockholders are owners of the firm.
Stockholders are residual claimants.
Stockholders have the right to:
 vote at company meetings
 dividends and other distributions
 sell their shares
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Stockholders benefit in two ways:
 dividends
 capital gains
Issuing and Trading Stock
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Stock is issued by public corporations to
finance investments.
Stock is initially issued in the primary
market (IPOs and secondary offerings).
Stock is traded in the secondary
market on organized exchanges.
World Stock Markets
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New York
Tokyo
London
Frankfurt
Paris
Mexico
Canada
Brussels
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Hong Kong
Singapore
Johannesburg
Sydney
Stockholm
Milan
Amsterdam
Switzerland
Major U.S. Stock Exchanges
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New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Over-The-Counter (OTC)
 National Association of Securities Dealers
(NASDAQ)
Major U.S. Stock Indices
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Dow Jones Industrial Average
Standard & Poors 500
NYSE Composite
NASDAQ Composite
Value Line
Russell 2000
Wilshire 5000
Transactions Involving Stocks

Buy
 Savings motive
 Expect stock to appreciate in value
 Long position
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Sell
 Liquidity needs
 Expect stock to decline in value
Transactions Involving Stock

Short Sell
 Sell stock without first owning it.
 Borrow stock from your broker with the
promise to repay it at some later date.
 Sell the borrowed stock.
 Repurchase it at a later date to repay your
broker.
 Responsible for all dividends and other
distributions while short the stock.
Stock Valuation
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The price an investor is willing to pay for a
share of stock depends upon:
 Magnitude and timing of expected future
dividends.
 Risk of the stock.
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The stock’s discount rate, re, is the rate of
return investors can expect to earn on
securities with similar risk.
Stock Valuation:
Dividend Discount Model

The value of a stock is the present
value of all future dividends:
P0 
d1
d2

...
dn
b1  r g b1  r g b1  r g
1
2
e
n
P0  
t 1
e
dt
b1  r g
t
e
n
e
Simplifying the Dividend
Discount Model
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Constant Dividends
d
P0 
re
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Constant Growth
d1
P0 
re  g
Constant Dividends:
RJR Nabisco Preferred Stock

RJR Nabisco has a preferred stock
outstanding with an annual dividend of
$2.50 per share. If securities with similar
risk are expected to return 9.6%, what is
the price of the preferred stock?
2.50
P0 
 $26.04
0.096
Constant Growth:
Duke Power Common Stock
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Duke Power currently pays a dividend of
$2.04 per share. With demand for
electric power growing at 4% per year,
and inflation averaging 3% per year, Duke
Power expects its profits and dividends to
grow at about 7% per year. If
stockholders require a 12% rate of return,
what is the market price of Duke Power’s
common stock?
Duke Power (cont.)
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Duke Power’s common stock price:
d1
P0 
re  g
2.04(107
. )
P0 
 $43.66
012
.  0.07
Valuing a Business
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Consider a company with cash flows from operations
of $1 million for the most recent year.
The company’s cash flows are expected to grow at a
rate of 10% for the next 5 years and at a constant
rate of 5% thereafter.
To generate this increase in cash flows, the company
is required to reinvest 50% of its cash flows for the
first 5 years and 25% of its cash flows thereafter.
Given the risk of the business, the required rate of
return is 15%.
What is the value of the business?
Valuing a Business (cont.)
Operating
Cash Flows
New Capital
Investment
Net Cash
Flow (Div)
Present
Value
Year 1
1.10
Year 2
1.21
Year 3
1.33
Year 4
1.46
Year 5
1.61
-0.55
-0.61
-0.67
-0.73
-0.81
0.55
0.60
0.66
0.73
0.80
0.48
0.45
0.43
0.42
0.40
Valuing a Business
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Value of dividends over the first 5 years
is $2.18.
Value of business at the end of the 5th
year:
d6
161
. (1  0.25)105
.
P5 

 $12.68
re  g
015
.  0.05
Valuing a Business (cont.)
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Value of the Business:
5
P0  
t 1
dt
P5

b1  r g b1  r g
P0  2.18 
t
5
e
e
12.68
 $8.48
. g
b115
5
Estimating Relevant Cash
Flows
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The relevant cash flows for evaluating a
new investment project are the
incremental cash flows contributed by
the project.
Incremental = Firm’s CFs - Firm’s CFs
Cash Flows with Project without Project
Estimating Relevant Cash
Flows: Basic Principles
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Discount Cash Flows, Not Accounting
Profits.
» For capital budgeting purposes, the point of
recognition is when the money is actually
received or spent.
» Don’t forget the effect of taxes.
Estimating Relevant Cash
Flows: Basic Principles
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Separate Investment and Financing
Decisions
» Ignore all financing costs, even if the project is
partially financed with debt.
» Treat the project as if it were all-equity
financed.
» Financing side effects will be considered later.
Estimating Relevant Cash
Flows: Basic Principles
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Only Incremental Cash Flows are
Relevant.
» Include all incidental effects, including
project interactions.
» Don’t forget to include investment in
working capital.
» Forget about sunk costs.
» Include all opportunity costs (e.g., land
used to construct a new plant).
» Beware of allocated overhead expenses.
Depreciation
Depreciation is a non-cash expense that
only affects cash flows through its tax
effect.
 Assets are depreciated down to their
estimated salvage values.
 Any removal costs associated with old
equipment are expensed immediately.
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Depreciation
Sales tax, delivery costs, and installation
are regarded as part of the cost of the new
asset for depreciation purposes.
 Removal costs of the old asset are not
regarded as part of the cost of the new
asset and are expensed immediately.
 If an asset is later sold for an amount
above (below) its book value, the excess is
taxable (deductible).
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Example: Estimating Cash Flows
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A new machine costs $60,000 plus
installation costs of $2,000. It
generates revenues of $155,000 and
expenses of $100,000 annually. It will
be depreciated to its estimated salvage
value over of $6,000 over its seven year
life. What are the relevant cash flows?
Step 1: Compute Tax Cash Flow
Year
Revenues
Expenses
Depreciation
Taxable Income
Tax
0
1
155,000
-100,000
-8,000
47,000
15,980
...
...
...
...
...
...
7
155,000
-100,000
-8,000
47,000
15,980
Step 2: Compute Cash Flows
Year
Revenues
Expenses
Tax
Cost of Machine
Salvage
Net Cash Flow
0
1
155,000
-100,000
-15,980
...
...
...
...
6
155,000
-100,000
-15,980
7
155,000
-100,000
-15,980
39,020
6,000
45,020
-62,000
-62,000
39,020
...