FIN 3701 Chapter 4 :Preferred and Common Stocks Stock Valuation Assumption University of Thailand “Genius is 90% perspiration and 10% inspiration” FIN3701 Chapter 4 T. Edison Corporate Preferred and Finance Common Stocks Warren Buffet Source: http://www.quotespin.com Dr. Chainarin Srinutchasart Source: http://bgr.com 1 2 Objectives Principles Applied in This Chapter • In this chapter, you will learn • Principle 1: Money Has a Time Value. • Features of preferred stock • Principle 2: There is a Risk-Reward Tradeoff. • Determining preferred stock values • Principle 3: Cash Flows are the Source of • Features of common stock Value. • Determining common stock values • Principle 4: Market Prices Reflect Information. • Principle 5: Individuals Respond to Incentives. 3 4 Corporate Finance addresses The Balance-Sheet Model of the the following 3 questions: Firm The Capital Structure Decision (Ch. 12, 15, 18) 1. What long-term investments should the firm (Financing Decision) engage in? 2. How can the firm raise money for the Current Liabilities required investments? (Alternatives: Bonds, Current Assets How can the Long-Term Debt This ch. Stocks, Preferred Stocks=what is the firm raise the money appropriate price?) Fixed Assets for the required 3. How much short-term cash flow does a 1 Tangible investments? Shareholders’ company need to pay its bills? and how to 2 Intangible Equity raise it 5 6 1 FIN 3701 Chapter 4 :Preferred and Common Stocks Debt vs. Equity Preferred Stock “Raising the capital: Tools” Fixed Claim Residual Claim Tax Deductible Not Tax Deductible High Priority in Financial Trouble Lowest Priority in Financial Trouble Fixed Maturity Infinite No Management Control Management Control Debt Hybrid Securities Equity Bank Debt Convertible Debt Owner's Equity Commercial Paper Preferred Stock Venture Capital Corporate Bonds Option-linked Bonds Common Stock Warrants What we will cover for this chapter 7 Source: http://i0.sinaimg.cn 8 Preferred Stock Preferred Stock A hybrid security: • Usually sold for $25, $50, or $100 per share. • It’s like common stock - no fixed maturity. • Dividends are fixed either as a dollar amount • Technically, it’s part of equity capital. or as a percentage of par value. • It’s like debt - preferred dividends are fixed. • Example: In 1988, Xerox issued $75 million of 8.25% preferred stock at $50 per share. • Missing a preferred dividend does not constitute default, but preferred dividends • $4.125 is the fixed, annual dividend per are cumulative. (and preferred dividends share. need to be paid before common stock’s dividends) 9 10 When to issue a preferred stock? Preferred Stock Features • The company already has too high level of • Firms may have multiple classes of debt. preferreds, each with different features. • Priority: lower than debt, higher than • And they don’t want to dilute the ownership common stock. (Claim of EBIT) interest of common stock holders. • **Cumulative feature: all past unpaid preferred stock dividends must be paid before any common stock dividends are declared. 11 12 2 FIN 3701 Chapter 4 :Preferred and Common Stocks Preferred Stock Features Preferred Stock Valuation • PIK Preferred: Pay-in-kind preferred stocks • A preferred stock can usually be valued pay additional preferred shares to investors like a perpetuity: rather than cash dividends. • Retirement: Most preferreds are callable, and many include a sinking fund provision to set cash aside for the purpose of retiring preferred shares. Source: http://www.palmbeachperfumes.com 13 14 Type of Value Security Valuation • Book value: value of an asset as shown on a • In general, the intrinsic value of an asset = firm’s balance sheet; historical cost. the present value of the stream of expected • Market value: observed value of an asset in cash flows discounted at an appropriate the marketplace; determined by supply and required rate of return. demand. • Intrinsic value: economic or fair value of an • Can the intrinsic value of an asset differ asset; the present value of the asset’s from its market value? expected future cash flows. 15 16 Valuation Preferred Stock Valuation • Discount the Preferred stock’s cash flows n (Dividend) at the investor’s required rate of $Ct return. V = S(1 + k)t t = 1 • Ct = cash flow to be received at time t. • k = the investor’s required rate of return. • V = the intrinsic value of the asset. 17 18 3 FIN 3701 Chapter 4 :Preferred and Common Stocks Preferred Stock Valuation Mathematically, • Discount the preferred stock’s cash flows at 1 the investor’s required rate of return. 1 – (1 + i)n • The DIV payment stream (perpetuity). (PVIFA i, n ) = i We said that a perpetuity is an annuity where n = infinity. What happens to this formula when n gets very, very large? 19 20 When n gets very large, So, Preferred Stock Valuation • A preferred stock can usually be valued like 1 this becomes zero. a perpetuity: 1 – (1 + i)n i D Vps = 1 ps So we’re left with PVIFA = k i 21 22 Example: Expected Rate of Return on Preferred • Xerox preferred pays an 8.25% dividend on a $50 par value. • Just adjust the valuation model: • Suppose our required rate of return on Xerox preferred is 9.5%. D 4.125 kps = Vps = = $43.42 Po .095 23 24 4 FIN 3701 Chapter 4 :Preferred and Common Stocks Example Example • If we know the preferred stock price is $40, • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the and the preferred dividend (Annually) is expected return is: $4.125, the expected return is: D 4.125 k ps = = = Po 40 25 26 Example • If we know the preferred stock price is $40, and the preferred dividend is $4.125, the expected return is: Common Stocks D 4.125 k ps = = = .1031 Po 40 27 28 Common Stock Debt vs. Equity “Raising the capital: Tools” Fixed Claim Residual Claim Tax Deductible Not Tax Deductible High Priority in Financial Trouble Lowest Priority in Financial Trouble Fixed Maturity Infinite No Management Control Management Control Debt Hybrid Securities Equity Bank Debt Convertible Debt Owner's Equity Common stock = owner Commercial Paper Preferred Stock Venture Capital Corporate Bonds Option-linked Bonds Common Stock Bond = creditor Warrants Preferred stock = hybrid What we will cover for this chapter Source: http://computerwoche.de 29 30 5 FIN 3701 Chapter 4 :Preferred and Common Stocks Common Stock: Owners, Directors, Common Stock and Managers (In theory) • Is a variable-income security. • Represents ownership in a corporation. • Dividends may be increased or decreased, • Ownership implies control. depending on earnings. • Stockholders elect directors. Agency • Includes voting rights. Cost • : liability is limited to amount • Directors hire management. arises Limited liability • Since managers are “agents” of of owners’ investment. shareholders, their goal should be: • Priority: lower than debt and preferred. Maximize stock price. (That’s why we need to know how to value a stock) 31 32 Understanding Stock Share Terms Understanding Stock Share Terms • Authorized Shares – These shares represent the • Restricted Shares – Restricted shares refer to total number of shares of stock authorized when company stock used for employee incentive and the company was created. Only a vote by the compensation plans. Restricted stockowners need shareholders can increase this number of shares. permission of the SEC to sell. There is a waiting period after a company first goes public where However, just because a company authorized a insiders’ restricted stock is frozen. When insiders certain number of shares doesn’t mean it must want to sell their stock, they must file a form with issue all of them to the public. Most companies the SEC declaring their intention. Even insiders of retain shares for use later called unissued stock or established companies must file with the SEC shares. before selling their restricted stock. • Unissued Shares – Shares a company retains in • Float Shares – Float refers to the number of its treasury and not issued to the public or to shares actually available for trade on the open employees are unissued shares. market. You and I can buy these shares. 33 34 Understanding Stock Share Terms Here’s a simple example with numbers to illustrate the relationship of these • Outstanding Shares – Outstanding shares different shares: includes all the shares issued by the company, which would be the restricted shares plus the float. • Authorized Shares – 100 • Treasury Shares – Previously issued stock that has been repurchased by the company. Buying • Unissued Shares – 20 treasury stock is an alternative to paying • Restricted Shares – 10 dividends. Since outstanding shares will be fewer • Float – 70 (100 – 20 – 10 = 70) after stock has been repurchased, EPS will rise. • Outstanding Shares – 80 (10 + 70 = 80) 35 36 6 FIN 3701 Chapter 4 :Preferred and Common Stocks Why is this Important? Why is this Important? • Look at the relationship of unissued shares • If the float of a company is very small and the and restricted shares to float for where stock attracts attention of investors it can controlling interest of the company will reside. become volatile because of supply and demand imbalances. Many companies retain a large percentage of More buyers will drive the price up, which is the authorized shares in their treasuries or in not a bad thing if you own the stock. the hands of management through restricted However, it may make the stock over priced shares. Companies do this to make sure no relative to its earnings or other fundamental other company can seize control in an measures. unfriendly takeover. They may also want to Likewise, if the stock falls out of favor, sellers have stock handy for future issue instead of may have trouble unloading their shares, using debt to buy another company or for which would tend to force the price down further and more rapidly than fundamentals another major expenditure.