Stock Valuation: Principles of Managerial Finance Chapter 7

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Questions and Answers

What is the main difference between debt and equity?

Debt is repaid based on the firm's performance, while equity is shares owned by private investors

Debt is repaid according to a fixed schedule of payments, while equity is funds provided by the firm's owners (correct)

Debt consists of funds provided by the firm's owners, while equity is repaid according to a fixed schedule of payments

Debt is repaid based on the firm's performance, while equity includes all borrowing incurred by a firm

Stockholders have voting rights in the firm, unlike debtholders.

True

What is the main advantage of debt financing over equity financing for a firm?

tax deductibility of interest

What is the definition of cumulative preferred stock?

Preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders. Signup and view all the answers

What is the definition of noncumulative preferred stock?

Preferred stock for which passed (unpaid) dividends do not accumulate. Signup and view all the answers

What does the Common Stock Dividend Valuation Model Equation 7.1 represent?

The value today of common stock based on the present value of expected cash flows. Signup and view all the answers

What does the Zero-Growth Dividend Model assume?

A constant, nongrowing dividend stream. Signup and view all the answers

What is the Gordon Growth Dividend Model also known as?

Constant-Growth Dividend Model. Signup and view all the answers

What does the Variable-Growth Dividend Model allow for?

A change in the dividend growth rate. Signup and view all the answers

What is the free cash flow stock valuation model?

A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firm's weighted average cost of capital. Signup and view all the answers

What is free cash flow?

The cash flow available to investors, including providers of debt and equity, after the firm meets all of its other obligations. Signup and view all the answers

What is the weighted average cost of capital (WACC)?

The firm's expected average future cost of funds over the long run. Signup and view all the answers

What is the formula for the present value of a stock using the free cash flow model?

VC = FCF1 / (1 + rWACC) + FCF2 / (1 + rWACC)^2 + ... + FCF∞ / (1 + rWACC)^∞ Signup and view all the answers

What is the value of common stock, VS?

The value of the entire company, VC, minus the market value of debt, VD, and preferred stock, VP. Signup and view all the answers

What is book value per share?

The amount per common share remaining if all of the firm's assets were sold for their exact book (accounting) value and if its liabilities (including preferred stock) were paid at book value. Signup and view all the answers

What is the new required return on Procter & Gamble stock if the risk-free rate remains at 1% and the required return is raised by 8%?

9% Signup and view all the answers

What is liquidation value per share?

The amount per common share remaining if all of the firm's assets were sold for their market value and liabilities (including preferred stock) were paid in full. Signup and view all the answers

What is the price/earnings (P/E) multiple approach?

A technique used to estimate the firm's share value by multiplying the firm's earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry. Signup and view all the answers

Calculate the new share value of Procter & Gamble stock with D1 = $3.09, r = 0.09, and g = 0.046.

$70.23 Signup and view all the answers

How does raising the required return without an increase in expected dividends impact the firm's stock value?

Decreases Signup and view all the answers

What happens to a firm's value when expected dividends increase?

The firm's value increases, as long as stockholders perceive no increase in the risk of the future dividend stream. Signup and view all the answers

What is the share price of Procter & Gamble stock after increasing dividend growth from 4.6% to 5% and required return from 7% to 9%?

$77.25 Signup and view all the answers

What happens to a firm's value when risk increases?

The firm's value decreases, as the required return increases to compensate for the higher risk. Signup and view all the answers

Increasing risk more than dividend growth is beneficial for the firm's owners.

False Signup and view all the answers

Study Notes

Stock Valuation

Differences Between Debt and Equity

Debt:
- Includes all borrowing incurred by a firm
- Repaid according to a fixed schedule of payments
Equity:
- Consists of funds provided by the firm's owners (investors or stockholders)
- Repaid subject to the firm's performance
Key differences:
- Voice in management: Stockholders have voting rights, while debtholders do not
- Claims on income and assets: Stockholders' claims are secondary to those of creditors
- Maturity: Debt has a fixed maturity date, while equity is permanent
- Tax treatment: Interest payments to debtholders are tax-deductible, while dividend payments to stockholders are not

Common and Preferred Stock

Common Stock:
- Ownership: Privately owned, publicly owned, or closely owned
- Par value: An arbitrary value established for legal purposes
- Preemptive rights: Allow common stockholders to maintain their proportionate ownership when new shares are issued
- Authorized, outstanding, and issued shares: Authorized shares are the maximum allowed, outstanding shares are issued and held by investors, and issued shares are the sum of outstanding and treasury stock
- Voting rights: Stockholders have voting rights, which can be exercised directly or by proxy
- Dividends: Payments made to stockholders at the discretion of the board of directors
Preferred Stock:
- Has a higher priority claim on the firm's current income and assets than common stock
- Typically has a fixed periodic dividend
- Has a higher claim on assets in liquidation than common stock
- May have cumulative or noncumulative dividend features
- May have a conversion feature to common stock

Common Stock Valuation

Dividend Valuation Model:
- Estimates the value of a share of common stock as the present value of its expected cash flows
- Can be used to value companies with a stable dividend policy
Zero-Growth Dividend Model:
- Assumes a constant, non-growing dividend stream
- Uses the formula: P0 = D1 / r
Constant-Growth Dividend Model (Gordon Growth Dividend Model):
- Assumes dividends will grow at a constant rate
- Uses the formula: P0 = D1 / (r - g)
Variable-Growth Dividend Model:
- Allows for a change in the dividend growth rate
- Uses a four-step process to estimate the value of the stock### Personal Finance and Common Stock Valuation
Broadcom, a leading semiconductor company, experienced high growth rates in its early years but eventually slowed down.
The company started paying dividends in 2010 and increased them rapidly over the next decade.
To estimate the value of Broadcom stock, a 10% required rate of return and a 20% growth rate for the next three years were assumed, followed by a 3% growth rate indefinitely.

Steps to Estimate Stock Value

Step 1: Estimate dividends for the next three years based on a 20% increase each year.
Step 2: Calculate the present value of the next three dividends using a 10% discount rate.
Step 3: Calculate the value of the stock at the end of the initial growth period (2023) using the constant-growth dividend model.
Step 4: Add the present value of the initial dividend stream to the present value of the stock at the end of the initial growth period to obtain the current value of Broadcom stock.

Free Cash Flow Stock Valuation Model

The model determines the value of an entire company as the present value of its expected free cash flows discounted at the firm's weighted average cost of capital.
Free cash flow is the cash flow available to investors after the firm meets all its other obligations.
The model is particularly useful for valuing firms with no dividend history or startups, or for valuing an operating unit or division of a larger public company.

Example of Free Cash Flow Valuation

Ruth's Hospitality Group reported free cash flow of $24.83 million and was expected to grow at a 7% rate for five years before settling down to a long-run growth rate of 4%.
The value of the entire company was calculated using the free cash flow valuation model, and the value of the common stock was obtained by subtracting the market value of debt and preferred stock.

Other Approaches to Common Stock Valuation

Book Value: The amount per common share remaining if all of the firm's assets were sold for their exact book value and if its liabilities (including preferred stock) were paid at book value.
Liquidation Value: The amount per common share remaining if all of the firm's assets were sold for their market value and liabilities (including preferred stock) were paid in full.
Price/Earnings (P/E) Multiples: A popular technique used to estimate the firm's share value by multiplying the firm's earnings per share (EPS) by the average price/earnings (P/E) ratio for the industry.

Decision Making and Common Stock Value

Changes in Expected Dividends: Any management action that causes stockholders to raise their dividend expectations should increase the firm's value.
Changes in Risk: Any action by the financial manager that increases the risk shareholders must bear will also raise the risk premium required by shareholders and hence the required return.
Combined Effect: A financial decision rarely affects dividends and risk independently; most decisions affect both factors, often in the same direction.

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Description

Understand the basics of stock valuation, differentiate between debt and equity, and apply the basic valuation model to stocks. This quiz covers the learning goals of Chapter 7 of Principles of Managerial Finance, 16th Edition.