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         CHAPTER 7
  Stocks and Their Valuation

 Financial markets and Institutions
 Features of common stock
 Determining common stock
 Efficient markets
 Preferred stock


 When raising capital:
 Direct transfer occurs when :-
   Small businesses
   Economies where financial markets and
    institutions are not well developed
 Indirect transfer occurs in developed
  economies because they find it more efficient to
  enlist the services of one or more financial
  institutions (Financial intermediaries) to raise



 Investment banking houses
 An investment bank often is a division or
  subsidiary of a larger company.
  1. Advise corporations regarding the
     design and pricing of new securities
  2. Buy these securities from the issuing
  3. Resell them to investors.


 Deposit-Taking Financial Intermediaries
 Financial Institutions take deposits from
  savers and then lend most of the
  deposited money to borrowers.
  Savings and Loan Associations
  Credit Unions.
  Commercial Banks


 Investment Funds
 At some financial institutions, savers have
  an ownership interest in a pool of funds
  rather than owning a deposit account.
  Mutual funds
  Money market funds


 Insurance Companies and Pension Funds
  pension funds
  Life insurance companies

            Financial markets

   Financial markets: allocate funds
    from surplus units to deficit units
 Based on Transaction Time: Spot
  Markets / Futures Markets
    Assets are being bought or sold for
    “on-the-spot” delivery (within few
    days) versus for delivery at some
    future date (six months, a year, etc.)

 Classification of Financial Markets:

 Based on Maturity: Money Markets
  / Capital Markets
   Money markets are the markets for short
    term (one year or less), highly liquid debt
    securities (T-Bills, Commercial Papers,
    Banker Acceptance, Repos, etc.).
   Capital markets are markets for long
    term debt and corporate stocks (T-
    Bonds, Corporate Bonds, Mortgages,
    Equity Securities, etc.).
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  Classification of Financial Markets:

 Based on Issuance: Primary Markets /
  Secondary Markets
   Primary markets are the markets in
    which corporations raise capital by
    issuing new securities.
   Secondary markets are the markets in
    which financial assets are traded among
    investors after they have been issued by
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          Financial markets

 Based on Location: Organized
  Markets / OTC Markets
   Organized markets (exchanges) are
    the markets, which operate in a
    visible marketplace.
   OTC (over-the-counter) markets are
    the markets, which operate over
    telecommunication network.
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   The value of any financial asset (a stock, a bond) is
    simply the present value of the cash flows the asset
    is expected to produce.
   While it is easy to predict the cash flows received
    from bonds, forecasting the cash flows on common
    stocks is much more difficult.
   However, two fairly straightforward models can be
    used to help estimate the “true,” or intrinsic, value
    of a common stock
    1. The dividend growth model.
    2. The total corporate value model
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      Legal Rights and Privileges of
         Common Stockholders
 The common stockholders are the owners of a
  corporation and as such they have certain rights
  and privileges
 Control of the Firm
  Common stockholders have the right to elect
  firm’s directors, who, in turn, (hire) elect the
  officers who manage the business.
   right to vote (may be mot)
   proxy fight.
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Common Stock: Owners, Directors,
        and Managers
Represents ownership.
Ownership implies control.
Stockholders elect directors.
Directors hire management.
Since managers are “agents” of
 shareholders, their goal should be:
 Maximize stock price.
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      Legal Rights and Privileges of
         Common Stockholders

 The Preemptive Right
  The Preemptive right is the right to purchase
  any additional shares sold by the firm.
  There are two primary reasons for the existence
  of the preemptive right
  1. maintain control
  2. Prevents a transfer of wealth from current
     stockholders to new stockholders
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        Types of Common Stock

 Most firms have only one type of
 common stock, in some instances
 classified stock and Tracking stock is
 used to meet the special needs of the
Classified stock
Tracking stock
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  What’s classified stock? How might
      classified stock be used?

Classified stock has special provisions.
Could classify existing stock as
 founders’ shares, with voting rights but
 dividend restrictions.
New shares might be called “Class A”
 shares, with voting restrictions but full
 dividend rights.
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         What is tracking stock?
The dividends of tracking stock are tied
 to a particular division, rather than the
 company as a whole.
  Investors can separately value the
  Its easier to compensate division
   managers with the tracking stock.
 But tracking stock usually has no
 voting rights, and the financial
 disclosure for the division is not as
 regulated as for the company.
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 Types of Stock Market Transactions

   We can classify stock market
   transactions into three distinct types:
1. Trading in the outstanding shares of
   established, publicly owned
   companies: the secondary market.
2. Additional shares sold by established,
   publicly owned companies: the
   primary market.
3. Initial public offerings by privately held
   firms: the IPO market.
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 When is a stock sale an initial public
           offering (IPO)?

A firm “goes public” through an IPO
 when the stock is first offered to the
Prior to an IPO, shares are typically
 owned by the firm’s managers, key
 employees, and, in many situations,
 venture capital providers.
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  What is a seasoned equity offering

A seasoned equity offering occurs
 when a company with public stock
 issues additional shares.
After an IPO or SEO, the stock trades
 in the secondary market, such as the
 NYSE or Nasdaq.
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Managerial Actions to Maximize
    Shareholder Wealth
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        Common Stock Valuation

 Common stock represents an ownership
  interest in a corporation, but to the typical
  investor a share of common stock is simply
  a piece of paper characterized by two
  1. It entitles its owner to dividends, if the
     company has earnings and chooses to
     pay dividends rather than retaining and
     reinvesting all the earnings
  2. Stock can be sold at some future date,
     hopefully at a price greater than the
     purchase price (capital gain.).
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   Definitions of Terms Used in Stock
            Valuation Models
 Common stocks provide an expected future cash
  flow stream.
 A stock’s value is found in the same manner as the
  values of other financial assets, as the present value
  of the expected future cash flow stream
 The expected cash flows consist of two elements:
   1. The dividends expected in each year and
   2. The price investors expect to receive when they
      sell the stock.
      The expected final stock price includes the
      original investment plus an expected capital gain.
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  Definitions of Terms Used in Stock
           Valuation Models
 Dt dividend the stockholder expects to
  receive at the end of Year t.
  • D0 is the most recent dividend, which has
    already been paid
  • D1 is the first dividend expected, and it will
    be paid at the end of this year.
  D2 is the dividend expected at the end of
   two years; and so forth.
 P0 actual market price of the stock today
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  Definitions of Terms Used in Stock
           Valuation Models
 Pt expected price of the stock at the end
  of each Year t.
    P0 is the intrinsic, or fundamental,
     value of the stock today as seen by
     the particular investor doing the
    P1 is the price expected at the end of
     one year ; and so on.
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  Definitions of Terms Used in Stock
           Valuation Models
 g expected growth rate in dividends as
  predicted by a marginal investor.
 rs minimum acceptable, or required, rate of
  return on the stock, considering both its
  riskiness and the returns available on other
 r^ expected rate of return that an investor
  who buys the stock expects to receive in the
 rs actual, or realized, after-the-fact rate of
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                 Quiz 1 (Bond Value)
Callaghan Motors’ bonds have 10 years remaining to
maturity. Interest is paid annually, the bonds have a
$1,000 par value, and the coupon interest rate is 8
percent. The bonds have a yield to maturity (market rate)
of 8 percent.
1- What is the current market price of these bonds?

2- If The bonds have a yield to maturity (market rate) of 9 percent
What is the current market price of these bonds?

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