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FM NOTES CHAP 7, STOCK VALUATIONS

Differences Between Debt and Equity

Debt includes all borrowing incurred by a firm,


including bonds, and is repaid according to a fixed
schedule of payments.
Equity consists of funds provided by the firms owners
(investors or stockholders) that are repaid subject to the
firms performance.
Debt financing is obtained from creditors and equity
financing is obtained from investors who then become
part owners of the firm.
Creditors (lenders or debtholders) have a legal right to be
repaid, whereas investors only have an expectation of

being repaid.

Differences Between Debt and Equity: Voice in Management

Unlike creditors, holders of equity (stockholders) are owners of the firm.


Stockholders generally have voting rights that permit them to select the firms directors and vote on
special issues.
In contrast, debtholders do not receive voting privileges but instead rely on the firms contractual
obligations to them to be their voice.
Differences Between Debt and Equity: Claims on Income and Assets
Equityholders claims on income and assets are secondary to the claims of creditors.
o Their claims on income cannot be paid until the claims of all creditors, including both interest
and scheduled principal payments, have been satisfied.
Because equity holders are the last to receive distributions, they expect greater returns to
compensate them for the additional risk they bear.
Differences Between Debt and Equity: Maturity
Unlike debt, equity capital is a permanent form of financing.
Equity has no maturity date and never has to be repaid by the firm.
Differences Between Debt and Equity: Tax Treatment
Interest payments to debtholders are treated as tax-deductible expenses by the issuing firm.
Dividend payments to a firms stockholders are not tax-deductible.
The tax deductibility of interest lowers the corporations cost of debt financing, further causing it to
be lower than the cost of equity financing.

COMMON AND PREFERRED STOCK: COMMON STOCK


Common stockholders, referred to as residual owners or residual claimants, are the true owners of
the firm.
receive what is leftthe residualafter all other claims on the firms income and assets have been
satisfied.
cannot lose any more than they have invested in the firm.
PAR VALUE of common stock is an arbitrary value established for legal purposes in the firms
corporate charter, and can be used to find the total number of shares outstanding by dividing it into
the book value of common stock.
Authorized shares are the shares of common stock that a firms corporate charter allows it to
issue.
Outstanding shares are issued shares of common stock held by investors, this includes private
and public investors.
Treasury stock are issued shares of common stock held by the firm; often these shares have been
repurchased by the firm.
Issued shares are shares of common stock that have been put into circulation.
Issued shares = outstanding shares + treasury stock
PREFERRED STOCK
Preferred stock gives its holders certain privileges that make them senior to common
stockholders.
Preferred stockholders are promised a fixed periodic dividend, which is stated either as a
percentage or as a dollar amount.
Par-value preferred stock is preferred stock with a stated face value that is used with the
specified dividend percentage to determine the annual dollar dividend.

No-par preferred stock is preferred stock with no stated face value but with a stated annual
dollar dividend.
Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a
fixed periodic payment (dividend).
Preferred stock is unlike debt in that it has no maturity date.
Because they have a fixed claim on the firms income that takes precedence over the claim of
common stockholders, preferred stockholders are exposed to less risk.
Preferred stockholders are not normally given a voting right, although preferred stockholders are
sometimes allowed to elect one member of the board of directors.
Cumulative preferred stock is preferred stock for which all passed (unpaid) dividends in arrears,
along with the current dividend, must be paid before dividends can be paid to common
stockholders.
Noncumulative preferred stock is preferred stock for which passed (unpaid) dividends do not
accumulate.
A callable feature is a feature of callable preferred stock that allows the issuer to retire the shares
within a certain period time and at a specified price.
A conversion feature is a feature of convertible preferred stock that allows holders to change
each share into a stated number of shares of common stock.
COMMON STOCK VALUATION: BASIC COMMON STOCK VALUATION EQUATION

Common Stock Valuation: Variable-Growth Model


Step 1.
Find the value of the cash dividends at the end of each year, Dt,
during the initial growth period, years 1 though N.
Step 2. Find the present value of the dividends expected
during the initial growth period.
Step 3.
Find the value of the stock at the end of the initial growth
period, PN = (DN+1)/(rs g2), which is the present value of all dividends
expected from year N + 1 to infinity, assuming a constant dividend
growth rate, g2.

Step 4.
Add the present value components found in
Steps 2 and 3 to find the value of the stock, P0.

Step 1; cari Dt u semua tahun termasuk thun infiniti


step 2: cari PV ;PVIF
t
Do
Dt = Do X FVIFg1 ; n,period
Dt x PVIF rs; n
1
a
a x FVIF g1 ; n,period = b
b x PVIF rs; 1 =B
2
b
b x FVIF g1 ; n,period = c
c x PVIF rs; 2 =C
3
c
c x FVIF g1 ; n,period = d
d x PVIF rs; 3 =D
4
B+C+D = E
Step 3 ; cari P3 = D4/rs g2 =( d x FVIFg2; 1period) / (rs g2)
Pastu cari PV; (P3 x PVIFrs; n) = F
Step4 : E+F
Common Stock Valuation:
Market Efficiency
Economically rational buyers and sellers use their assessment of an assets risk and return to
determine its value.
In competitive markets with many active participants, the interactions of many buyers and
sellers result in an equilibrium pricethe market valuefor each security.
Because the flow of new information is almost constant, stock prices fluctuate, continuously
moving toward a new equilibrium that reflects the most recent information available. This
general concept is known as market efficiency.
The efficient-market hypothesis (EMH) is a theory describing the behavior of an assumed
perfect market in which:
securities are in equilibrium,
security prices fully reflect all available information and react swiftly to new information,
and
because stocks are fully and fairly priced, investors need not waste time looking for
mispriced securities
Although considerable evidence supports the concept of market efficiency, a growing body of
academic evidence has begun to cast doubt on the validity of this notion.

Behavioral finance is a growing body of research that focuses on investor behavior and its impact
on investment decisions and stock prices. Advocates are commonly referred to as behaviorists.
Understanding Human Behavior Helps Us Understand Investor Behavior
Regret theory deals with the emotional reaction people experience after realizing they
have made an error in judgment.
Some investors rationalize their decision to buy certain stocks with everyone else is
doing it. (Herding)
People have a tendency to place particular events into mental compartments, and the
difference between these compartments sometimes impacts behavior more than the
events themselves.
Prospect theory suggests that people express a different degree of emotion toward
gains than losses.
Anchoring is the tendency of investors to place more value on recent information.