LEARNING OBJECTIVES

• Explain how stock prices depend on future dividends

and dividend growth.
• Show how to value stocks using multiples.
• Lay out the different ways corporate directors are
elected to office.
• Define how the stock markets work.

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 CHAPTER OUTLINE
• Common Stock Valuation.
• Some Features of Common and Preferred Stocks.
• The Stock Markets.

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 COMMON STOCK VALUATION
• Share of common stock is more difficult to value in practice
than a bond for at least three reasons:

1. With common stock, not even the promised cash flows are
known in advance.
2. Life of the investment is essentially forever because common
stock has no maturity.
3. No way to easily observe the rate of return that the market
requires.

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HOW COMMON STOCKS ARE VALUED

Expected Return - The percentage yield that an

investor forecasts from a specific investment over a
set period of time. Sometimes called the market
capitalization rate.

Div1  P1  P0
Expected return  r 
P0
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 CASH FLOWS 1

Imagine you are considering buying a share of stock today. You plan to
sell the stock in one year. You somehow know that the stock will be
worth $70 at that time. You predict the stock will also pay a $10 per
share dividend at the end of the year. If you require a 25% return on
your investment, what is the most you would pay for the stock? In
other words, what is the present value of the $10 dividend along with
the $70 ending value at 25%?
• Present value = ($10 + 70)/1.25 = $64.

Let P0 be the current price of the stock, and assign P1 to be the price in
one period. If D1 is the cash dividend paid at the end of the period and
R is the required return in the market on this investment , then:
P0   D1  P1  1  R 
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 CASH FLOWS 2

• Suppose we somehow knew the price in two periods, P2. Given a predicted
dividend in two periods, D2, the stock price in one period would be:
P1   D2  P2  1  R 

• Substitute this expression for P1 into our expression for P0.

D  P2
D1  2
D P 1 R
P0  1 1 
1 R 1 R
D1 D2 P2
  
1  R  1  R  1  R 
1 2 2

• The price of the stock today is equal to the present value of all of the future
dividends.
D1 D2 D3 D4 D5
P0       ...
1  R  1  R  1  R  1  R  1  R 
1 2 3 4 5
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 GROWTH STOCKS 1

You might be wondering about shares of stock in companies such as

Alphabet that currently pay no dividends. Small, growing companies
frequently plow back everything and pay no dividends. Are such shares
worth nothing? It depends. When we say that the value of the stock is equal
to the present value of the future dividends, we don’t rule out the possibility
that some number of those dividends are zero. They just can’t all be zero.
Imagine a company that has a provision in its corporate charter that
prohibits the paying of dividends now or ever. The corporation never
borrows any money, never pays out any money to stockholders in any form
whatsoever, and never sells any assets. Such a corporation couldn’t really
exist because the IRS wouldn’t like it, and the stockholders could always vote
to amend the charter if they wanted to. If it did exist, however, what would
the stock be worth?

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 GROWTH STOCKS 2

The stock would be worth absolutely nothing. Such a

company would be a financial “black hole.” Money goes in, but
nothing valuable ever comes out. Because nobody would ever
get any return on this investment, the investment would have
no value. This example is a little absurd, but it illustrates that
when we speak of companies that don’t pay dividends, what we
really mean is that they are not currently paying dividends.

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 ZERO GROWTH
• A share of common stock in a company with a constant dividend is much like a
share of preferred stock.
• Dividend on a share of preferred stock has zero growth and is constant through
time; for a zero-growth share of common stock, this implies that:
D1  D2  D3  D  Constant
• Value of the stock is:
D D D D D
P0       ...
1  R  1  R  1  R  1  R  1  R 
1 2 3 4 5

• Stock may be viewed as ordinary perpetuity with cash flow equal to D every
period, with the per-share value given by:

P0  D R

• Where R is the required return.

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 CONSTANT GROWTH 1

• Suppose we know that the dividend for some company always grows at a steady
rate. Call this growth rate g. If we let D0 be the dividend just paid, then the next
dividend, D1, is:
D1  D0  1  g 

• The dividend in two periods is:

D2  D1  1  g 
  D0  1  g   1  g 

 D0  1  g 
2

• We could repeat this process to come up with the dividend at any point in the
future.
• The dividend t periods into the future, Dt, is given by:

Dt  D0  1  g 
t
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 CONSTANT GROWTH 2

• The dividend growth model determines the current price of

a stock as its dividend next period divided by the discount
rate less the dividend growth rate, and can be written as
follows, so long as the growth rate, g, is less than the
discount rate, r:
D0  1  g  D1
P0  
Rg Rg
• We can use the dividend growth model to get the stock price
at any point in time; in general, the price of the stock as of
Time t is:
Dt  1  g  Dt  1
Pt  
© McGraw Hill
Rg Rg 14-11
8-11
 CONSTANT GROWTH
(CONCLUDED)
• Suppose D0 is $2.30, R is 13%, and g is 5%. The price per share in this case is:
P0 = D0 × (1 + g)/(R − g)
= $2.30 × 1.05/(. 13 − . 05 )
= $2.415 / .08
= $30.19

• Suppose we are interested in the price of the stock in five years, P5. We first need
the dividend at Time 5, D5. Because the dividend just paid is $2.30 and the growth
rate is 5% per year, D5 is:
D5 = $2.30 × 1.055 = $2.30 × 1.2763 = $2.935
• The price of the stock in five years is:

D5  1  g  $2.935  1.05 $3.0822

P5     $38.53
Rg .13  .05 .08
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 NONCONSTANT GROWTH 1

Main reason to consider this case is to allow for “supernormal” growth rates over
some finite length of time.
• Require dividends start growing at a constant rate sometime in future.

Consider the case of a company that is currently not paying dividends. You predict
that, in five years, the company will pay a dividend for the first time. The dividend will
be $.50 per share. You expect that this dividend will then grow at a rate of 10% per
year indefinitely. The required return on companies such as this one is 20%. What is
the price of the stock today?
1. Find out what it will be worth once dividends are paid; price in four years will be:
• P4 = D4 × (1 + g)/(R − g) = D5/(R − g) = $.50 /( .20 − .10) = $5.
2. If the stock will be worth $5 in four years, then we can get the current value by
discounting this price back four years at 20%:
• P0 = $5/1.204 = $5/2.0736 = $2.41.
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 NONCONSTANT GROWTH 2

• Suppose you have come up with the following dividend forecasts for the next
three years. After the third year, the dividend will grow at a constant rate of 5%
per year. The required return is 10%. What is the value of the stock today?
Year Expected Dividend
1 $1.00
2 $2.00
3 $2.50

• In dealing with nonconstant growth, a time line can be helpful.

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Access the text alternative for slide images.
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 NONCONSTANT GROWTH
(CONCLUDED)
• Value of the stock is the present value of all the future dividends:

1. Compute the PV of the stock price three years down the road.
P3  D3  1  g   R  g 
 $2.50  1.05 .10  0.5 
 $52.50
3. Add in the PV of dividends that will be paid between now and then.
D1 D2 D3 P3
P0    
1  R  1  R  1  R  1  R 
1 2 3 3

$1 2 2.50 52.50
   
1.10 1.10 1.10 1.103
2 3

 $.91  1.65  1.88  39.44

 $43.88 14-15
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 TWO-STAGE GROWTH
In this case, the dividend will grow at a rate of g1 for t years and then grow at a rate
of g2 thereafter, forever.
The value of the stock can be written as:
• First term in expression is the PV of a growing annuity.
• In first stage, g1 can be greater than R.
• Second part is PV of stock price once second stage begins at Time t.
D1   1  g1 t  Pt
P0   1     
R  g1   1  R   1  R t

We can calculate Pt as follows:

• In this second stage, g2 must be less than R.

D  1  g1   1  g 2 
t
Dt 1
Pt   0
R  g2 R  g2

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 TWO-STAGE GROWTH: AN EXAMPLE 1

The Highfield Company’s dividend is expected to grow at 20 percent for the next five
years. After that, the growth is expected to be 4 percent forever. If the required
return is 10 percent, what’s the value of the stock? The dividend just paid was $2.
There is a fair amount of computation here, but it is mostly just “plug and chug” with
a calculator. We can start by calculating the stock price five years from now, P5:
D  1  g1   1  g 2 
5
D6
P5   0
R  g2 R  g2
$2  1  .20   1  .04 
5
$5.18
 
.10  .04 .06
 $86.26

We then plug this result into our two-stage growth formula to get the price today:

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 TWO-STAGE GROWTH: AN EXAMPLE 2

D1   1  g1  
t
Pt
P0   1    
R  g1   1  R   1  R t

$2  1  .20    1  .20   $86.26

5

  1    
  1  .10 
5
.10  .20   1  .10
 $66.64
Notice that we were given D0 = $2 here, so we had to grow it by
20 percent for one period to get D1. Notice also that g1 is bigger
than R in this problem, but that fact does not cause an issue.

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 COMPONENTS OF THE REQUIRED
RETURN
Earlier, we calculated P0 as: P0 = D1/(R − g). If we rearrange this to solve for R, we get:

R  g  D1 P0
R  D1 P0  g
Total return, R, has two components:
1. Dividend yield is a stock’s expected cash dividend divided by its current price
(That is, D1/P0).
2. Dividend growth rate, g, can be interpreted as the capital gains yield, the rate at
which the value of an investment grows.
Suppose we observe a stock selling for $20 per share. The next dividend will be $1 per
share. You think that the dividend will grow by 10% per year more or less indefinitely.
What return does this stock offer if this is correct?
• R = Dividend yield + Capital gains yield.
• R = $1/$20 + .10 = .05 + .10 = .15, or 15%.
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 WEIGHTED AVERAGE COST OF
CAPITAL
• WEIGHTED AVERAGE COST OF CAPITAL: To fund long-term project and assets, firms generally raise capital

through various sources such as equity, debt and preference shares. Each of these sources of capital has

a different cost or required rate of return reflecting varying degree of risk attached to it.

• For example, in case of equity, the returns expected by the shareholders would act as the cost of equity

or cost for the retained earnings. Similarly, cost of debt and cost of preference shares represents the

returns expected by the bondholders and preference shareholders respectively.

• Weighted Average Cost of Capital (WACC) represents the weighted average of the cost or rate of returns

required by the equity, debt and preference shares investors of a company, the weights being the

proportion of equity, debt and preference shares in the total capital of the firm.

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 REQUIRED RETURN VERSUS
COST OF CAPITAL
• The terms required return, appropriate discount rate, and cost of
capital essentially mean the same thing:
• If the required return on an investment is 10%, we mean the
investment will have a positive NPV only if its return exceeds 10%
• Also, the firm must earn 10% on the investment to compensate
investors for the use of the capital needed to finance the project
• Furthermore, 10% is the cost of capital associated with the
investment

• Cost of capital associated with an investment depends on the risk

of that investment, not how and where the capital is raised

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FINANCIAL POLICY AND COST OF CAPITAL

• The particular mixture of debt and equity a firm chooses to employ

—its capital structure—is a managerial variable

• In this chapter, we will assume the firm has a fixed debt-equity

ratio that it maintains
• This ratio reflects the firm’s target capital structure

• Recall, a firm’s overall cost of capital will reflect the required return
on the firm’s assets as a whole
• Thus, a firm’s cost of capital will reflect both its cost of debt capital
and its cost of equity capital

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WACC

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 THE COST OF EQUITY:
DIVIDEND GROWTH MODEL APPROACH
• Cost of equity is the return that equity investors require on their
investment in the firm
• No way to directly observe the return the firm’s equity investors
require, so we must estimate the firm’s overall cost of equity
• Dividend growth model approach is the easiest way to estimate
the cost of equity capital
• If we assume the firm’s dividend will grow at a constant rate, g,
allow D0 to represent the dividend just paid and D1 to represent
the next period’s projected dividend, the price per share of the
stock, P0, can be written as:

• We can rearrange this to solve for RE, the required return on the
stock (i.e., firm’s cost of equity capital), as follows:
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 DIVIDEND GROWTH MODEL APPROACH
• We need three pieces of information to estimate RE:
• P0 and D0 can be observed directly for publicly traded, dividend-
paying firms
• g must be estimated
• Suppose Greater States Public Service, a large public utility, paid a
dividend of $4 per share last year. The stock currently sells for $60
per share. You estimate that the dividend will grow steadily at a
rate of 6% per year into the indefinite future. What is the cost of
equity capital for Greater States?
• We can calculate the expected dividend for the coming year, D1, is:
D1 = D0 × (1 + g)
= $4 × 1.06 = $4.24
• Given this, the cost of equity, RE, is:
RE = D1/P0 + g 14-25
= $4.24/$60 + .06 = .1307, or 13.07%
DIVIDEND GROWTH MODEL APPROACH:
ESTIMATING THE GROWTH RATE
• To estimate the growth rate, we can use historical growth rates or
analysts’ forecasts of future growth rates
• Suppose we observe the following for some company:

• We can calculate the percentage change in the dividend per year

and then average the four growth rates to derive an estimate for g,
(.0909 + .1250 + .0370 + .1071)/4 = .09, or 9%:

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 DIVIDEND GROWTH MODEL APPROACH:
ADVANTAGES AND DISADVANTAGES
• Primary advantage of dividend growth model is its simplicity

• Several associated practical problems and disadvantages:

• Applicable only to firms that pay dividends, and even for those
companies that pay dividends, a key underlying assumption is that
the dividend grows at constant rate
• Estimated cost of equity is very sensitive to estimated growth rate
• Does not explicitly consider risk

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 THE SML APPROACH
• Recall, the required or expected return on a risky investment
depends on three things:
1. Risk-free rate, Rf
2. Market risk premium, E(RM) − Rf
3. Systematic risk of the asset relative to the average, which we
called its beta coefficient, β

• Using SML, we can write the expected return on the company’s

equity, E(RE), as follows, where βE is the estimated beta:
• E(RE) = Rf + βE × [E(RM) − Rf]

• Dropping the Es denoting expectations, the required return form

the SML, RE, can be written as:
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 IMPLEMENTING THE SML APPROACH
• To use the SML approach, we need the following:
1. A risk-free rate, Rf
• U.S. T-bills were paying about 1.53% as this chapter was being
written, so we will use this as our risk-free rate
2. An estimate of the market risk premium, E(RM) − Rf
• One estimate of the market risk premium (based on large common
stocks) is about 7%
3. An estimate of the relevant beta, βE
• Beta coefficients for publicly traded companies are widely available

• We saw Walt Disney had an estimated beta of 1.11. We could

estimate Walt Disney’s cost of equity as:
RWalt Disney = Rf + βWalt Disney × (RM − Rf)
= .0153 + 1.11 × .07
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= .0930, or 9.30%
 ADVANTAGES AND DISADVANTAGES OF
THE SML APPROACH
• SML approach has two primary advantages:
• It explicitly adjusts for risk
• It is applicable to companies other than just those with steady
dividend growth

• Disadvantages include the following:

• SML approach requires that two things be estimated (the market
risk premium and the beta coefficient) and if those estimates are
poor, the resulting cost of equity will be inaccurate
• As with the dividend growth model, we essentially rely on the past
to predict the future when we use the SML approach

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THE COST OF EQUITY

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 THE COST OF DEBT
• Cost of debt is the return that lenders require on the firm’s debt
• No need to estimate a beta for the debt because the cost of debt
can normally be observed either directly or indirectly:
• Cost of debt, RD, is interest rate firm must pay on new borrowing,
and we can observe interest rates in the financial markets
• Note the coupon rate on the firm’s outstanding debt is irrelevant,
as this rate tells us what the firm’s cost of debt was back when the
bonds were issues, not what the cost of debt is today

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14-33
• Cost of Debt: Refers to return required by debtholders. The
interest payments by a firm are tax deductible, and hence,
the cost of debt should be considered post-tax.
• ✓Cost of debt can be assumed as the traded yield of
company in the market.
• ✓In case the given bond is not traded in the market, yield of
comparable bond (in terms of Industry as well as Rating) can
be taken as proxy for the given bond.

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 THE COST OF PREFERRED STOCK
• Preferred stock has a fixed dividend paid every period forever, so a
share of preferred stock is essentially a perpetuity. The cost of
preferred stock, RP, is thus:

• D is the fixed dividend

• P0 is the current price per share of the preferred stock

• Cost of preferred stock is equal to the dividend yield on the

preferred stock

• Preferred stocks are rated in much the same way as bonds, so the
cost of preferred stock can be estimated by observing the required
returns on other, similarly rated shares of preferred stock 14-35
14-36
14-37
ALABAMA POWER CO.’S COST OF
PREFERRED STOCK

14-38
 THE WEIGHTED AVERAGE COST OF
CAPITAL
• Use E to represent market value of firm’s equity, calculated by
multiplying number of shares outstanding and price per share
• Use D to represent market value of firm’s debt, calculated by
multiplying market price of single bond and bonds outstanding
• If there are multiple bonds issues, repeat this calculation of D for
each and then add up the results
• If there is debt that is not publicly traded, observe the yield on
similar publicly traded debt and then estimate the market value of
the privately held debt using this yield as the discount rate
• Use V to represent combined market value of the debt and equity:

• Dividing both sides by V, we can calculate percentages of the total

capital represented by the debt and equity (i.e., capital structure
weights), which can be interpreted just like portfolio weights:

14-39
 TAXES AND THE WEIGHTED AVERAGE
COST OF CAPITAL
• Recall the interest paid by a corporation is deductible for tax
purposes, but payments to stockholders, such as dividends, are not
• In determining an aftertax discount rate, we need to distinguish
between the pretax and the aftertax cost of debt
• Suppose a firm borrows $1 million at 9% interest. The corporate tax
rate is 21%. What is the aftertax interest rate on this loan?
• Total interest bill will be $90,000 per year, but this amount is tax
deductible, so the $90,000 interest reduces the firm’s tax bill by .21
× $90,000 = $18,900
• Aftertax interest bill is $90,000 − 18,900 = $71,100
• Aftertax interest rate is $71,100/$1 million = .0711, or 7.11%
• Generally, aftertax interest rate equals pretax rate multiplied by 1
minus tax rate
• If we use the symbol TC to stand for the corporate tax rate, then the
aftertax rate can be written as RD × (1 − TC) 14-40
 TAXES AND THE WEIGHTED AVERAGE
COST OF CAPITAL (CONTINUED)
• To calculate the firm’s overall cost of capital, we multiply the capital
structure weights by the associated costs and add them up, with the
total being the weighted average cost of capital (WACC):

• WACC has straightforward interpretation:

• It is the overall return the firm must earn on its existing assets to
maintain the value of its stock
• It is also the required return on any investments by the firm that
have essentially the same risks as existing operations
• If a firm uses preferred stock in its capital structure, and we define
P/V as the percentage of the firm’s financing that comes from
preferred stock and RP as the cost of preferred stock, the WACC is:

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 THE WAREHOUSE PROBLEM
• Suppose you have just become the president of a large company,
and the first decision you face is whether to go ahead with a plan to
renovate the company’s warehouse distribution system. The plan
will cost the company $50 million, and it is expected to save $12
million per year after taxes over the next six years.
• Need to find an alternative in the financial markets that is
comparable to warehouse renovation (i.e., has same level of risk)

• Suppose the firm has a target debt-equity ratio of 1/3, which implies
that E/V is .75 and D/V is .25. The cost of debt is 10%, and the cost
of equity is 20%. Assuming a 21% tax rate, the WACC will be:
WACC = (E/V) × RE + (D/V) × RD × (1 − TC)
= .75 × . 20 + .25 × . 10 × ( 1 − .21)
= .1698, or 16.98%
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SUMMARY OF CAPITAL COST
CALCULATIONS

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