# Fin 311 Chapter 07 Handout by ashrafp

VIEWS: 17 PAGES: 4

• pg 1
```									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.