Stocks and Valuation

Stocks and Their Valuation

• Common stockholders have control of a firm because they can elect the firm's directors.
• The condition where the expected return on a security equals its required return is equilibrium.
• There generally are large differences between realized returns and expected returns.
• The price of a stock is the present value of all expected future dividends, discounted at the investors required return.
• Constant growth model valuation formula: P₀ = (D₁)/(Kₛ - g) = (D₀(1+g))/(Kₛ - g)
• In the constant growth model of valuing stocks, dividends are assumed to grow at a constant rate.
• Two firms with the same dividend and growth rate do not necessarily have the same stock price.
• Since preferred stock dividends are fixed, valuing preferred stock is roughly equivalent to valuing a zero-growth common stock.
• An initial public offering (IPO) occurs when a company's stock is offered to the public for the first time.
• If the market is semistrong-form efficient, you cannot expect to outperform the overall market by observing the past price history of an individual stock.
• Studies almost unanimously show that you cannot make an abnormal profit in the U.S. market by using inside information.

The Cost of Capital

• A firm's capital structure policy affects its weighted average cost of capital.
• The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.
• The yield to maturity on existing debt is usually a good estimate of the before-tax cost of new debt.
• When calculating the component cost of debt for capital budgeting purposes for profitable, tax-paying firms, the tax adjustment reduces the component cost of debt.
• There is no tax effect to consider when calculating the component cost of preferred stock for capital budgeting purposes.
• The cost of new common stock (external equity) is generally higher than the cost of retained earnings (internal equity) because of flotation costs.
• Accounts payable and accruals are not considered a capital component for calculating the weighted average cost of capital (WACC) as it applies to capital budgeting.
• The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component that makes up the firm's target capital structure.
• An increase in its net income will increase a company's retained earnings break point.
• There is no step that would mitigate the necessity to raise new common stock.

The Basics of Capital Budgeting

• The process of planning expenditures on assets whose cash flows are expected to extend beyond one year is called capital budgeting.
• Independent projects are projects whose cash flows are not affected by the acceptance of other projects.
• Mutually exclusive projects are a set of projects where only one can be accepted.
• A major disadvantage of the payback period is that it ignores cash flows beyond the payback period and does not directly account for the time value of money.
• NPV indicates a project is deemed desirable (acceptable) when the NPV is greater than or equal to zero.
• The NPV calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the firm's cost of capital.
• IRR indicates a project is deemed desirable (acceptable) when the IRR is greater than or equal to the risk-adjusted cost of capital.
• The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the return on the particular project examined.
• All else equal, a projects NPV increases as the cost of capital declines, assuming the project has normal cash flows.
• Internal rate of return (IRR), net present value (NPV), and payback period method are alternative techniques of doing capital budgeting analysis.