Fin 311 Chapter 07 Handout

							Chapter 7 – Equity Markets and Stock Valuation
The price of any financial instrument is the present value of the future cash flows.

Preferred Stock
There is a 6 percent preferred share outstanding. If investors have a required return of 7 percent
on this stock, what is the price?

           D
    P0 =
           R




Common stock
Assumption: The dividends grow at a constant rate forever. The following equation goes by
many names. Here are a few:

    Gordon Growth Model
    Discounted Dividend Model
    Dividend Model

            D1   D (1  g)
    P0         = 0
           R -g   R -g




Suppose a stock will pay a dividend of $2.50 next year and the dividends will grow at 6 percent
forever. If the required return is 13 percent, what is the price per share today?




Fin 311 Chapter 7 Handout                                                                     Page 1
Suppose a stock just paid a dividend of $1.80 and the dividends will grow at 6 percent
indefinitely. If the required return is 11 percent, what is the current stock price?

                  D1
         P0 
                 R -g




What is the stock price in 8 years?

                  D9
         P8 
                 R -g




What is the stock price in 15 years?

                 D16
         P15         =
                 R -g




Page 2                                                                    Fin 311 Chapter 7 Handout
Growing Perpetuities
You want to buy a song catalog. The royalties next year will be $1 million, and are expected to
decrease by 8 percent per year indefinitely. If you want a 13 percent return, what is the most you
should pay for the catalog?




Where does g come from?




Required Return
We can solve the Gordon Growth Model for R, the required return.

             D1    D 1  g 
        R      g 0         g
             p0       P0




Fin 311 Chapter 7 Handout                                                                    Page 3
We are analyzing a stock with a current price of $25 per share. The current dividend (D0) is $1
per share and is expected to grow at 4.5 percent per year indefinitely. What is the required return
for this stock?




We will not cover the non-constant growth section.



Read Sections 7.2 and 7.3




Page 4                                                                      Fin 311 Chapter 7 Handout