1
Finance School of Management
Chapter 9
Valuation of Common Stocks
Objective
Explain equity evaluation
using discounting
Dividend policy
and wealth
2
Finance School of Management
Contents
? Introduction
? Reading Stock Listings
? The Discounted Dividend model
? Earnings and Investment Opportunities
? A Reconsideration of the Price/Earnings
Multiple Approach
? Does Dividend Policy Affect Shareholder
Wealth?
3
Finance School of Management
Introduction
? Common stock is the best known security,
but many people know comparatively little
about it,
? People who own stock have an equity
interest in the organization,
? If a business has shares of stock,it is
organized as a corporation rather than a
proprietorship or a partnership,
4
Finance School of Management
Introduction
? Shareholder Rights,
?the right to receive declared dividends on a pro
rata basis
?the right to vote
?the right to maintain ownership percentage
5
Finance School of Management
Reading Stock Listings
52 Weeks
Hi Lo Stock Sym Div Yld % PE Vol100s Hi Lo Close Net Chg
25.38 20.38 IBM IBM 1.54 7.2 12 371 21.25 20.88 21.25 +.13
Dividend Yield
Div
C lose?
Price/Earnings
Ratio
市盈率
6
Finance School of Management
The Discounted Dividend Model
? Chapter 8 shows how the Law of One Price can be
used to deduce the value of known cash flows from
the observed market prices of bonds,
? In this chapter we consider the valuation of uncertain
cash flows using a discounted cash flow (DCF)
approach,
? The DCF approach to determining the value of a
stock discounts the expected cash flows-either
dividends paid to shareholders or net cash flows
from trading,
Assume,buy and hold for
ever
7
Finance School of Management
The Discounted Dividend Model
? Discount-dividend model (DDM) is defined as
any model that computes the value of a share
of stock as the present value of its expected
future cash dividends,
? The risk-adjusted discount rate or market
capitalization rate is the expected rate of
return that investors require to be willing to
invest in the stock,
8
Finance School of Management
The Discounted Dividend Model
? The rate of return that investors expect,E(r1),
equals the market capitalization rate,k,
1 1 0
1
0
()
D P P
E r k
P
??
?? k
PD
P
?
?
?
1
11
0
The price is the present value of the
expected end-of-year dividend plus the
expected ex-dividend price discounted at
the required rate return,
9
Finance School of Management
The Discounted Dividend Model
? Using the same logic employed to derive P0,
the expected price of stock at the beginning
of the second year is,
22
1 1
DPP
k
??
?
? By substitution,we can express P0 in terms of
D1,D2,and P2,
1 2 2
0 21 ( 1 )
D D P
P
kk
?
??
??
10
Finance School of Management
The Discounted Dividend Model
? By repeating this chain of substitutions,we
get the general formula of the DDM,
12
0 2
1( 1 ) ( 1 ) ( 1 )
t
t
t
DDD
p
k k k
?
?
? ? ? ?
? ? ?
?
The price of a share of stock is the present
value of all expected future dividends per
share,discounted at the market
capitalization rate,
11
Finance School of Management
Does the trading behavior
affect the stock price？
12
Finance School of Management
Suppose that an investor buys one stock from the
beginning and sells it at time T with the selling
price PT 。 From the DDM,we have,
0
1 ( 1 ) ( 1 )
T
t T
tT
t
D P
P
kk?
??
???and
(1 )
t
T t
tT
D
P
k
?
?
?
??Therefore
0
11( 1 ) ( 1 ) ( 1 )
T
t t t
t t t
t t T t
D D D
P
k k k
??
? ? ?
? ? ?
? ? ?? ? ?
The trading behavior has no effect on stock price,
13
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? The most basic assumption is that
dividends will grow at a constant rate g,
? Substituting the dividend growth forecast,
Dt=D1(1+g)t-1,into DDM formula,we find
that the present value of a perpetual of
dividends growing at a constant rate,g,is
1
0
D
P
kg
?
?
14
Finance School of Management
IBM stock is expected to pay a dividend of $3
per share a year from now,and its dividends are
expected to grow by 8% per year thereafter,If its
price is now $30 per share,what must be the
market capitalization rate?
3
3 0 0,1 8
0,0 8
k
k
? ? ?
?
15
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? If g equals to zero(D1=D2=… ),the formula
reduces to the formula for the present
value of a level perpetuity,
11
0
1 ( 1 )
t
t
DD
P
kk
?
?
??
?
?
16
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? Another implication of the constant growth rate
DDM is that the stock price is expected to grow at
the same rate as dividends,
1 0 0 0
00
( 1 )P P P g P
g
PP
? ? ?
??
17
Finance School of Management
Earning and Investment Opportunity
? A second approach to DCF valuation focuses on
future earnings and investment opportunities,
? Focusing on earnings and investment
opportunities rather than dividend helps to
concentrate the analyst's attention on the core
business determinants of value,
? Consider an investor planning to take over the
firm,
18
Finance School of Management
Earnings and Investment Opportunities
? To simplify the analysis,suppose that no
new shares are issues,and no taxes,
? ? ? ? ? ????
?
?
?
?
?
? ?
?
?
?
?
?
111
0 111
t
t
t
t
t
t
t
t
t
k
I
k
E
k
D
p
? The formula for valuing stock is
Dividends = Earnings - Net New Investment
19
Finance School of Management
Earnings and Investment Opportunities
? The firm’s value equals the present value of
its expected future earning less the present
value of the earnings reinvested in the firm,
?In a declining industry,net investment is negative
and capacity would decline over time,
?In a stable or stagnant industry,net investment is
zero and capacity remains about constant over time,
?In an expanding industry,net investment is positive
and capacity increases over time,
20
Finance School of Management
Earnings and Investment Opportunities
? A useful way to estimate a firm’s value
based on earnings and investment
opportunities is to partition the firm’s value
into two parts,
?The present value of the current level of earnings
projected into the future as a perpetuity,and
?The net present value of any future investment
opportunities,
1
0
EP
k?
+ Net Present Value of Future Investment Opportunities
21
Finance School of Management
Earnings and Investment Opportunities
? For example,consider a firm called Nogrowth
Corporation,whose earnings per share are $15,It
pays all of its earnings out as dividends,and
there is no growth,
? Assuming that the capitalization rate is 15% per
year,Nogrowth's stock price would be,
P0 =$15/0.15=$100
22
Finance School of Management
? Growthstock initially has the same earnings as
Nogrowth,but it reinvests 60% of its earnings
each year into new investments that yield a rate of
return of 20% per year,
? Growthstock will pay out only 40% of $15 as
dividends,or $6 per share,
? Although Growth stock’s dividend per share is
initially lower than Nogrowth’s,Growth stock’s
dividends will grow over time,
g = Earnings Retention Rate × Rate of Return on New Investments
0
66 $200
0,1 5 0,1 2 0,0 3
P ? ? ?
?
g = 0.6
× 0.2=0.12
E I Eg
E E I
??? ? ?
23
Finance School of Management
? The net present value of Growth stock’s future
investments is the difference in price between
its shares and Nogrowth’s shares,
NPV of Future Investments =$200 - $100=$100
An analyst uses the constant growth DDM to
evaluate IBM stock,She assumes expected
earnings of $10 per share,an earnings retention
rate of 75%,an expected rate of return on
future investments of 18% per year,and a market
capitalization rate of 15% per year,What is the
implied net present value of future investments? Ans,$166.67-$66.67 = $100
24
Finance School of Management
? It is important to realize that the reason that
Growth stock has a higher share price than
Nogrowth is not growth per se,but rather the
fact that its reinvested earnings yield a rate of
return in excess of the market capitalization
rate,
? Normalprofit's rate of return on future
investments is 15% per year and it reinvests 60%
of its earnings each year,
g = 0.6 × 0.15=0.09
0
66 $100
0,1 5 0,0 9 0,0 6
P ? ? ?
?
25
Finance School of Management
26
Finance School of Management
? Growth per se does not add value,What
adds value is the opportunity to invest in projects
that can earn rates of return in excess of the
required rate,k,
? When a firm’s future investment opportunities
yield a rate of return equals to k,the stock’s
value can be estimated using the formula:P0=E1/k
Earnings and Investment Opportunities
0
( 1 ) ( 1 )
( 1 )
t
tt
Er E rt Ep
k r k k r k
? ?? ? ?
? ? ?
27
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
? A widely used approach for quickly estimating
the value of a share of a firm's stock is to take its
projected earnings per share and to multiply it
by an appropriate price/earnings (P/E) multiple
derived from other comparable firms,
28
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
? The expected earnings of Digital Biomed
Corporation per share are $2 per year,If you
apply the industry average P/E,which is 15,the
resultant value for Digital Biomed stock is $30,
? However,the actual price at which Digital
Biomed stock is trading in the stock market is
$100 per share,How can you account for the
difference?
29
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
It is not growth per se that produces a
high P/E ratio,but rather the presence of future
investment opportunities that are expected to
yield a rate of return greater than the market’s
required risk-adjusted rate,
1
0
EP
k
?
+ Net Present Value of Future Investment Opportunities
30
Finance School of Management
Effects of Dividend Policy
? Dividend policy means a corporation’s
regarding paying out cash to its
shareholders holding constant its
investment and borrowing decisions,
? Does dividend policy affect shareholder
wealth?
31
Finance School of Management
Cash Dividends & Share Repurchases
? Cash dividends
– All shareholders receive cash in amounts
proportional to the number of shares they own
– All else the same,the share price declines
immediately after payment by the amount of the
dividend
32
Finance School of Management
Cash Dividends & Share Repurchases
? Share repurchases
– The company pays cash to buy shares of its stock in
the stock market,reducing the number of shares
outstanding
– All else the same,the share price remains unchanged
33
Finance School of Management
Cash Dividends & Share Repurchases
? Stock dividends
– Corporations sometimes declare stock splits and
distribute stock dividend,These activities do not
distribute cash to shareholders; they increase the
number of shares of stock outstanding,
– Payment of a stock dividend can be seen as
distributing a cash dividend to existing shareholders,
and then requiring them to immediately use the cash
to buy additional shares of the company's stock,
– All else the same,the share price declines
immediately after payment of the dividend
34
Finance School of Management
Illustration,Cashrich Corporation
? Total assets with a market value of $12
million,$2 million in cash,and $10 million in
other assets
? The market value of its debts is $2 million
and of its equity $10 million
? 500,000 shares of common stock
outstanding,each with a market price of $20
35
Finance School of Management
Original Balance Sheet
A s s e t s L i a b \ E q u
C a s h 2 D e b t 2
O t h e r 10 E q u i t y 10
T o t a l 12 T o t a l 12
36
Finance School of Management
Dividend Payment
(a cash dividend of $2 per share,Price=$18)
A s s e t s L i a b \ E q u
C a s h 1 D e b t 2
O t h e r 10 E q u i t y 9
T o t a l 11 T o t a l 11
Was 2 Was 10
Were 12
37
Finance School of Management
Share Repurchase
(repurchases shares worth $1 million,Price=$20)
A s s e t s L i a b \ E q u
C a s h 1 D e b t 2
O t h e r 10 E q u i t y 9
T o t a l 11 T o t a l 11
Was 2 Was 10
Were 12
38
Finance School of Management
Stock Dividends
(10% stock dividend,550,000 shares outstanding,Price=$18.18)
Was 2 Was 10
Were 12
A s s e t s L i a b \ E q u
C a s h 2 D e b t 2
O t h e r 10 E q u i t y 10
T o t a l 12 T o t a l 12
39
Finance School of Management
Dividend Policy in Frictionless Financial
Environment—M&M Theory
?Does dividend policy affect stockholders’
wealth?
?Modigliani and Miller (1961) proves that
In a frictionless financial environment,
corporations cannot increase stockholders’
wealth through dividend policy,
no taxes and no
transaction costs
40
Finance School of Management
M&M Theory,Cashrich Corporation
? Instead of paying $1 million cash
dividends,the management of Cashrich
decides to invest it in a project,
? A stockholder,who holds 100 shares and
wants to receive a cash dividend of $2 per
share,can
– sell 10 shares for $200 cash
– his total wealth is 90 shares of stocks with a market
value of $1,800+$200 cash
41
Finance School of Management
M&M Theory,Cashrich Corporation
? Cashrich does distributes a cash dividend
of $2 per share
? A stockholder,who holds 100 shares and
does not wand to hold cash,can
– Use the cash dividends to buy shares with a value of
$200
– his total wealth is original 100 shares with a market
value of $1,800+news shares with a market value of
$200
42
Finance School of Management
Illustration,Cashpoor Corporation
? Total assets,$0.5 million in cash,and $1
million in plant and equipment
? The market value of its debts is $1 million
? A project with NPV of $1.5 million needs an
initial investment of $0.5 million for plant
and equipment
? 1,000,000 shares of common stock
outstanding,each with a market price of $2
43
Finance School of Management
Balance Sheet of Cashpoor
A s s e t s L i a b \ E q u
C a s h 0, 5 D e b t 1, 0
P l a n t & E q u i p m e n t 1, 0
N P V o f N e w I n v e s t m e n t 1, 5 E q u i t y 2, 0
T o t a l 3, 0 T o t a l 3, 0
44
Finance School of Management
M&M Theory,Cashpoor Corporation
? The stock price fully reflects all the
available information,including NPV of the
new investment
? If Cashpoor uses its $0.5 million to finance
the investment
– a $0.5 million reduction in the firm’s cash account
– an increase of $0.5 million in plant and equipment
– the stock price is still $2 per share
45
Finance School of Management
M&M Theory,Cashpoor Corporation
? If Cashpoor pays a cash dividend of $0.5
per share (total $0.5 million) to its
shareholders,and issues new stocks to
finance the purchase of plant and
equipment
– the stock price will decline from $2 to $1.5
– the wealth of old shareholders is still $2 million
– 333,333 new shares should be issued to raise the $0.5
million needed for the new plant and equipment
46
Finance School of Management
Dividend Policy in the Real World
? In the real world,there are a number of
frictions,taxes,regulations,the costs of
external finance,and the information content
of dividends
47
Finance School of Management
Dividend Policy in the Real World
? Personal taxes,paying cash dividends or
repurchasing shares
? Regulations,laws that prevent corporations
– from using shares repurchases as an alternative to
dividends as a regular mechanism for paying cash to
shareholders
– from retaining cash in the business that is not needed to
run the business
48
Finance School of Management
Dividend Policy in the Real World
? Cost of raising funds externally
– the fees the investment bankers charge
– a bargain price to induce outsiders to buy new shares
? Informational content of dividends
– a dividend increase,good sign and price increase
– a dividend decrease,bad sign and price decline
49
Finance School of Management
Review
? The discounted dividend model (DDM) shows that the
current price of a share is the present value of all
expected future dividends,
? In the constant growth rate DDM,the growth rate of
dividends is also the expected rate of price appreciation,
? Growth per se does not add value to a share's current
price,What adds value is the opportunity to invest in
projects that yield a rate of return in excess of the
market capitalization rate,
50
Finance School of Management
Review
? In a frictionless financial environment,the wealth of
shareholders is the same no matter what dividend policy
the firm adopts,
? In the real world there are a number of frictions that can
cause dividend policy to have an effect on the wealth of
shareholders,These include taxes,regulations,the costs
of external finance,and the informational content of
dividends,
51
Finance School of Management
Exercises
? P251,1,4
? P252,10
Finance School of Management
Chapter 9
Valuation of Common Stocks
Objective
Explain equity evaluation
using discounting
Dividend policy
and wealth
2
Finance School of Management
Contents
? Introduction
? Reading Stock Listings
? The Discounted Dividend model
? Earnings and Investment Opportunities
? A Reconsideration of the Price/Earnings
Multiple Approach
? Does Dividend Policy Affect Shareholder
Wealth?
3
Finance School of Management
Introduction
? Common stock is the best known security,
but many people know comparatively little
about it,
? People who own stock have an equity
interest in the organization,
? If a business has shares of stock,it is
organized as a corporation rather than a
proprietorship or a partnership,
4
Finance School of Management
Introduction
? Shareholder Rights,
?the right to receive declared dividends on a pro
rata basis
?the right to vote
?the right to maintain ownership percentage
5
Finance School of Management
Reading Stock Listings
52 Weeks
Hi Lo Stock Sym Div Yld % PE Vol100s Hi Lo Close Net Chg
25.38 20.38 IBM IBM 1.54 7.2 12 371 21.25 20.88 21.25 +.13
Dividend Yield
Div
C lose?
Price/Earnings
Ratio
市盈率
6
Finance School of Management
The Discounted Dividend Model
? Chapter 8 shows how the Law of One Price can be
used to deduce the value of known cash flows from
the observed market prices of bonds,
? In this chapter we consider the valuation of uncertain
cash flows using a discounted cash flow (DCF)
approach,
? The DCF approach to determining the value of a
stock discounts the expected cash flows-either
dividends paid to shareholders or net cash flows
from trading,
Assume,buy and hold for
ever
7
Finance School of Management
The Discounted Dividend Model
? Discount-dividend model (DDM) is defined as
any model that computes the value of a share
of stock as the present value of its expected
future cash dividends,
? The risk-adjusted discount rate or market
capitalization rate is the expected rate of
return that investors require to be willing to
invest in the stock,
8
Finance School of Management
The Discounted Dividend Model
? The rate of return that investors expect,E(r1),
equals the market capitalization rate,k,
1 1 0
1
0
()
D P P
E r k
P
??
?? k
PD
P
?
?
?
1
11
0
The price is the present value of the
expected end-of-year dividend plus the
expected ex-dividend price discounted at
the required rate return,
9
Finance School of Management
The Discounted Dividend Model
? Using the same logic employed to derive P0,
the expected price of stock at the beginning
of the second year is,
22
1 1
DPP
k
??
?
? By substitution,we can express P0 in terms of
D1,D2,and P2,
1 2 2
0 21 ( 1 )
D D P
P
kk
?
??
??
10
Finance School of Management
The Discounted Dividend Model
? By repeating this chain of substitutions,we
get the general formula of the DDM,
12
0 2
1( 1 ) ( 1 ) ( 1 )
t
t
t
DDD
p
k k k
?
?
? ? ? ?
? ? ?
?
The price of a share of stock is the present
value of all expected future dividends per
share,discounted at the market
capitalization rate,
11
Finance School of Management
Does the trading behavior
affect the stock price？
12
Finance School of Management
Suppose that an investor buys one stock from the
beginning and sells it at time T with the selling
price PT 。 From the DDM,we have,
0
1 ( 1 ) ( 1 )
T
t T
tT
t
D P
P
kk?
??
???and
(1 )
t
T t
tT
D
P
k
?
?
?
??Therefore
0
11( 1 ) ( 1 ) ( 1 )
T
t t t
t t t
t t T t
D D D
P
k k k
??
? ? ?
? ? ?
? ? ?? ? ?
The trading behavior has no effect on stock price,
13
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? The most basic assumption is that
dividends will grow at a constant rate g,
? Substituting the dividend growth forecast,
Dt=D1(1+g)t-1,into DDM formula,we find
that the present value of a perpetual of
dividends growing at a constant rate,g,is
1
0
D
P
kg
?
?
14
Finance School of Management
IBM stock is expected to pay a dividend of $3
per share a year from now,and its dividends are
expected to grow by 8% per year thereafter,If its
price is now $30 per share,what must be the
market capitalization rate?
3
3 0 0,1 8
0,0 8
k
k
? ? ?
?
15
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? If g equals to zero(D1=D2=… ),the formula
reduces to the formula for the present
value of a level perpetuity,
11
0
1 ( 1 )
t
t
DD
P
kk
?
?
??
?
?
16
Finance School of Management
The Constant-Growth-Rate,
Discounted Dividend Model
? Another implication of the constant growth rate
DDM is that the stock price is expected to grow at
the same rate as dividends,
1 0 0 0
00
( 1 )P P P g P
g
PP
? ? ?
??
17
Finance School of Management
Earning and Investment Opportunity
? A second approach to DCF valuation focuses on
future earnings and investment opportunities,
? Focusing on earnings and investment
opportunities rather than dividend helps to
concentrate the analyst's attention on the core
business determinants of value,
? Consider an investor planning to take over the
firm,
18
Finance School of Management
Earnings and Investment Opportunities
? To simplify the analysis,suppose that no
new shares are issues,and no taxes,
? ? ? ? ? ????
?
?
?
?
?
? ?
?
?
?
?
?
111
0 111
t
t
t
t
t
t
t
t
t
k
I
k
E
k
D
p
? The formula for valuing stock is
Dividends = Earnings - Net New Investment
19
Finance School of Management
Earnings and Investment Opportunities
? The firm’s value equals the present value of
its expected future earning less the present
value of the earnings reinvested in the firm,
?In a declining industry,net investment is negative
and capacity would decline over time,
?In a stable or stagnant industry,net investment is
zero and capacity remains about constant over time,
?In an expanding industry,net investment is positive
and capacity increases over time,
20
Finance School of Management
Earnings and Investment Opportunities
? A useful way to estimate a firm’s value
based on earnings and investment
opportunities is to partition the firm’s value
into two parts,
?The present value of the current level of earnings
projected into the future as a perpetuity,and
?The net present value of any future investment
opportunities,
1
0
EP
k?
+ Net Present Value of Future Investment Opportunities
21
Finance School of Management
Earnings and Investment Opportunities
? For example,consider a firm called Nogrowth
Corporation,whose earnings per share are $15,It
pays all of its earnings out as dividends,and
there is no growth,
? Assuming that the capitalization rate is 15% per
year,Nogrowth's stock price would be,
P0 =$15/0.15=$100
22
Finance School of Management
? Growthstock initially has the same earnings as
Nogrowth,but it reinvests 60% of its earnings
each year into new investments that yield a rate of
return of 20% per year,
? Growthstock will pay out only 40% of $15 as
dividends,or $6 per share,
? Although Growth stock’s dividend per share is
initially lower than Nogrowth’s,Growth stock’s
dividends will grow over time,
g = Earnings Retention Rate × Rate of Return on New Investments
0
66 $200
0,1 5 0,1 2 0,0 3
P ? ? ?
?
g = 0.6
× 0.2=0.12
E I Eg
E E I
??? ? ?
23
Finance School of Management
? The net present value of Growth stock’s future
investments is the difference in price between
its shares and Nogrowth’s shares,
NPV of Future Investments =$200 - $100=$100
An analyst uses the constant growth DDM to
evaluate IBM stock,She assumes expected
earnings of $10 per share,an earnings retention
rate of 75%,an expected rate of return on
future investments of 18% per year,and a market
capitalization rate of 15% per year,What is the
implied net present value of future investments? Ans,$166.67-$66.67 = $100
24
Finance School of Management
? It is important to realize that the reason that
Growth stock has a higher share price than
Nogrowth is not growth per se,but rather the
fact that its reinvested earnings yield a rate of
return in excess of the market capitalization
rate,
? Normalprofit's rate of return on future
investments is 15% per year and it reinvests 60%
of its earnings each year,
g = 0.6 × 0.15=0.09
0
66 $100
0,1 5 0,0 9 0,0 6
P ? ? ?
?
25
Finance School of Management
26
Finance School of Management
? Growth per se does not add value,What
adds value is the opportunity to invest in projects
that can earn rates of return in excess of the
required rate,k,
? When a firm’s future investment opportunities
yield a rate of return equals to k,the stock’s
value can be estimated using the formula:P0=E1/k
Earnings and Investment Opportunities
0
( 1 ) ( 1 )
( 1 )
t
tt
Er E rt Ep
k r k k r k
? ?? ? ?
? ? ?
27
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
? A widely used approach for quickly estimating
the value of a share of a firm's stock is to take its
projected earnings per share and to multiply it
by an appropriate price/earnings (P/E) multiple
derived from other comparable firms,
28
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
? The expected earnings of Digital Biomed
Corporation per share are $2 per year,If you
apply the industry average P/E,which is 15,the
resultant value for Digital Biomed stock is $30,
? However,the actual price at which Digital
Biomed stock is trading in the stock market is
$100 per share,How can you account for the
difference?
29
Finance School of Management
A Reconsideration of the
Price/Earnings Multiple Approach
It is not growth per se that produces a
high P/E ratio,but rather the presence of future
investment opportunities that are expected to
yield a rate of return greater than the market’s
required risk-adjusted rate,
1
0
EP
k
?
+ Net Present Value of Future Investment Opportunities
30
Finance School of Management
Effects of Dividend Policy
? Dividend policy means a corporation’s
regarding paying out cash to its
shareholders holding constant its
investment and borrowing decisions,
? Does dividend policy affect shareholder
wealth?
31
Finance School of Management
Cash Dividends & Share Repurchases
? Cash dividends
– All shareholders receive cash in amounts
proportional to the number of shares they own
– All else the same,the share price declines
immediately after payment by the amount of the
dividend
32
Finance School of Management
Cash Dividends & Share Repurchases
? Share repurchases
– The company pays cash to buy shares of its stock in
the stock market,reducing the number of shares
outstanding
– All else the same,the share price remains unchanged
33
Finance School of Management
Cash Dividends & Share Repurchases
? Stock dividends
– Corporations sometimes declare stock splits and
distribute stock dividend,These activities do not
distribute cash to shareholders; they increase the
number of shares of stock outstanding,
– Payment of a stock dividend can be seen as
distributing a cash dividend to existing shareholders,
and then requiring them to immediately use the cash
to buy additional shares of the company's stock,
– All else the same,the share price declines
immediately after payment of the dividend
34
Finance School of Management
Illustration,Cashrich Corporation
? Total assets with a market value of $12
million,$2 million in cash,and $10 million in
other assets
? The market value of its debts is $2 million
and of its equity $10 million
? 500,000 shares of common stock
outstanding,each with a market price of $20
35
Finance School of Management
Original Balance Sheet
A s s e t s L i a b \ E q u
C a s h 2 D e b t 2
O t h e r 10 E q u i t y 10
T o t a l 12 T o t a l 12
36
Finance School of Management
Dividend Payment
(a cash dividend of $2 per share,Price=$18)
A s s e t s L i a b \ E q u
C a s h 1 D e b t 2
O t h e r 10 E q u i t y 9
T o t a l 11 T o t a l 11
Was 2 Was 10
Were 12
37
Finance School of Management
Share Repurchase
(repurchases shares worth $1 million,Price=$20)
A s s e t s L i a b \ E q u
C a s h 1 D e b t 2
O t h e r 10 E q u i t y 9
T o t a l 11 T o t a l 11
Was 2 Was 10
Were 12
38
Finance School of Management
Stock Dividends
(10% stock dividend,550,000 shares outstanding,Price=$18.18)
Was 2 Was 10
Were 12
A s s e t s L i a b \ E q u
C a s h 2 D e b t 2
O t h e r 10 E q u i t y 10
T o t a l 12 T o t a l 12
39
Finance School of Management
Dividend Policy in Frictionless Financial
Environment—M&M Theory
?Does dividend policy affect stockholders’
wealth?
?Modigliani and Miller (1961) proves that
In a frictionless financial environment,
corporations cannot increase stockholders’
wealth through dividend policy,
no taxes and no
transaction costs
40
Finance School of Management
M&M Theory,Cashrich Corporation
? Instead of paying $1 million cash
dividends,the management of Cashrich
decides to invest it in a project,
? A stockholder,who holds 100 shares and
wants to receive a cash dividend of $2 per
share,can
– sell 10 shares for $200 cash
– his total wealth is 90 shares of stocks with a market
value of $1,800+$200 cash
41
Finance School of Management
M&M Theory,Cashrich Corporation
? Cashrich does distributes a cash dividend
of $2 per share
? A stockholder,who holds 100 shares and
does not wand to hold cash,can
– Use the cash dividends to buy shares with a value of
$200
– his total wealth is original 100 shares with a market
value of $1,800+news shares with a market value of
$200
42
Finance School of Management
Illustration,Cashpoor Corporation
? Total assets,$0.5 million in cash,and $1
million in plant and equipment
? The market value of its debts is $1 million
? A project with NPV of $1.5 million needs an
initial investment of $0.5 million for plant
and equipment
? 1,000,000 shares of common stock
outstanding,each with a market price of $2
43
Finance School of Management
Balance Sheet of Cashpoor
A s s e t s L i a b \ E q u
C a s h 0, 5 D e b t 1, 0
P l a n t & E q u i p m e n t 1, 0
N P V o f N e w I n v e s t m e n t 1, 5 E q u i t y 2, 0
T o t a l 3, 0 T o t a l 3, 0
44
Finance School of Management
M&M Theory,Cashpoor Corporation
? The stock price fully reflects all the
available information,including NPV of the
new investment
? If Cashpoor uses its $0.5 million to finance
the investment
– a $0.5 million reduction in the firm’s cash account
– an increase of $0.5 million in plant and equipment
– the stock price is still $2 per share
45
Finance School of Management
M&M Theory,Cashpoor Corporation
? If Cashpoor pays a cash dividend of $0.5
per share (total $0.5 million) to its
shareholders,and issues new stocks to
finance the purchase of plant and
equipment
– the stock price will decline from $2 to $1.5
– the wealth of old shareholders is still $2 million
– 333,333 new shares should be issued to raise the $0.5
million needed for the new plant and equipment
46
Finance School of Management
Dividend Policy in the Real World
? In the real world,there are a number of
frictions,taxes,regulations,the costs of
external finance,and the information content
of dividends
47
Finance School of Management
Dividend Policy in the Real World
? Personal taxes,paying cash dividends or
repurchasing shares
? Regulations,laws that prevent corporations
– from using shares repurchases as an alternative to
dividends as a regular mechanism for paying cash to
shareholders
– from retaining cash in the business that is not needed to
run the business
48
Finance School of Management
Dividend Policy in the Real World
? Cost of raising funds externally
– the fees the investment bankers charge
– a bargain price to induce outsiders to buy new shares
? Informational content of dividends
– a dividend increase,good sign and price increase
– a dividend decrease,bad sign and price decline
49
Finance School of Management
Review
? The discounted dividend model (DDM) shows that the
current price of a share is the present value of all
expected future dividends,
? In the constant growth rate DDM,the growth rate of
dividends is also the expected rate of price appreciation,
? Growth per se does not add value to a share's current
price,What adds value is the opportunity to invest in
projects that yield a rate of return in excess of the
market capitalization rate,
50
Finance School of Management
Review
? In a frictionless financial environment,the wealth of
shareholders is the same no matter what dividend policy
the firm adopts,
? In the real world there are a number of frictions that can
cause dividend policy to have an effect on the wealth of
shareholders,These include taxes,regulations,the costs
of external finance,and the informational content of
dividends,
51
Finance School of Management
Exercises
? P251,1,4
? P252,10
