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Exchange Trading of Listed Stocks

The NYSE is one of the preeminent securities exchanges in the world. All transactions in stocks listed on the NYSE occur at a particular place on the floor of the exchange called a post. At the heart of the market is the specialist. Specialists are members of the NYSE who make a market in designated stocks. Specialists have an obligation to offer to buy and sell shares of their assigned NYSE stocks. It is believed that this makes the market liquid because the specialist assumes the role of a buyer for investors if they wish to sell and a seller if they wish to buy.

Maximize Stock Prices The Best Case Scenario

If corporate financial theory is based on the objective of maximizing stock prices, it is worth asking when it is reasonable to ask managers to focus on this objective to the exclusion of all others. There is a scenario where managers can concentrate on maximizing stock prices to the exclusion of all other considerations and not worry about side costs. For this scenario to unfold, the following assumptions have to hold With these assumptions, there are no side costs to stock price maximization. Consequently, managers can concentrate on maximizing stock prices. In the process, stockholder wealth and firm value will be maximized and society will be made better off. The assumptions needed for the classical objective are summarized in pictorial form in figure 2.1. Figure 2.1 Stock Price Maximization The Costless Scenario

Maximize Stock Prices Real World Conflicts of Interest

Even a casual perusal of the assumptions that we need for stock price maximization to be the only objective when making decisions suggests that there are potential shortcomings in each one. Managers might not always make decisions that are in the best interests of stockholders, stockholders do sometimes take actions that hurt lenders, information delivered to markets is often erroneous and sometimes misleading and there are social costs that cannot be captured in the financial statements of the company. In the section that follows, we will consider some of the ways in which real world problems might trigger a break down in the stock price maximization objective.

Valuing Common Stocks

Dividend Discount Model - Computation of today's stock price which states that share value equals the present value of all expected future dividends. Valuing Common Stocks Dividend Discount Model - Computation of today's stock price which states that share value equals the present value of all expected future dividends.

Stock Market Indicators

Stock market indicators have come to perform a variety of functions, from serving as benchmarks for evaluating the performance of professional investors to answering the question How did the market do today Thus, stock market indicators (indexes or averages) have become a part of everyday life. The most commonly quoted stock market indicator is the Dow Jones Industrial Average (DJIA). Other stock market indicators cited in the financial press are the Standard & Poor's 500 Composite (S& P 500), the New York Stock Exchange Composite Index (NYSE Composite), the Nasdaq Composite Index, and the Value Line Composite Average (VLCA). Other stock market indicators include the Wilshire stock indexes and the Russell stock indexes, which are followed primarily by institutional money managers. The stocks included in a stock market indicator must be combined in certain proportions, and each stock must be given a weight. The three main approaches to weighting are these (1) weighting by the...

Stock Price Maximization and Social Welfare

If a firm attempts to maximize its stock price, is this good or bad for society In general, it is good. Aside from such illegal actions as attempting to form monopolies, violating safety codes, and failing to meet pollution requirements, the same actions that maximize stock prices also benefit society. Here are some of the reasons 1. To a large extent, the owners of stock are society. Seventy-five years ago this was not true, because most stock ownership was concentrated in the hands of a relatively small segment of society, comprised of the wealthiest individuals. Since then, there has been explosive growth in pension funds, life insurance companies, and mutual funds. These institutions now own more than 57 percent of all stock. In addition, more than 48 percent of all U.S. households now own stock directly, as compared with only 32.5 percent in 1989. Moreover, most people with a retirement plan have an indirect ownership interest in stocks. Thus, most members of society now have an...

Maximize Stock Prices Salvaging a Flawed Objective

The alternatives to stock price maximization - a corporate governance system build around self-governance or a different objective - have their own limitations. In this section, we consider the case for salvaging stock price maximization as an objective, but consider ways in which we can reduce some of the problems highlighted in the earlier section. In particular, we consider ways in which we can reduce the conflicts of interest between stockholders, bondholders and managers, and the potential for market failures. We also present an argument for stock price maximization based upon the market's capacity to correct systematic mistakes quickly and effectively.

The Falling Us Dollar During The Second Half Of 1987 Also Weighed On Stock Prices The Twin Peaks In The Us Currency In

Peaked in August along with the stock market. A second rally failure by the dollar in October and its subsequent plunge coincided almost exactly with the stock market selloff. It seems clear that the plunge in the dollar contributed to the weakness in equities. Consider the sequence of events going into the fall of 1987. Commodity prices had turned sharply higher, fueling fears of renewed inflation. At the same time interest rates began to soar to double digits. The U.S. dollar, which was attempting to end its two-year bear market, suddenly went into a freefall of its own (fueling even more inflation fears). Is it any wonder, then, that the stock market finally ran into trouble Given all of the bearish activity in the surrounding markets, it's amazing the stock market held up as well as it did for so long. There were plenty of reasons why stocks should have sold off in late 1987. Most of those reasons, however, were visible in the action of the surrounding markets and not necessarily...

Why Corporate Finance Focuses on Stock Price Maximization

Much of corporate financial theory is centered on stock price maximization as the sole objective when making decisions. This may seem surprising given the potential side costs listed above, but there are three reasons for the focus on stock price maximization in traditional corporate finance. Stock prices are the most observable of all measures that can be used to judge the performance of a publicly traded firm. Unlike earnings or sales, which are updated once every quarter or even once every year, stock prices are updated constantly to reflect new information coming out about the firm. Thus, managers receive instantaneous feedback from investors on every action that they take. A good illustration is the response of markets to a firm announcing that it plans to acquire another firm. While managers consistently paint a rosy picture of every acquisition that they plan, the stock price of the acquiring firm drops in roughly half of all acquisitions, suggesting that markets are much more...

Stock Price Movements

(i) Consider the evolution of a stock price the prices observed at successive moments in time St apart are S0, Si, , SN. For simplicity, it is assumed that no dividend is paid in this period. The price relative in period n is defined as the ratio Rn Sn Sn-i. This quantity is a random variable and we make the following apparently innocuous but far-reaching assumption the price relatives are independently and identically distributed. If the price relatives are independently distributed, the next move does not depend on what happened at the last move. This is a statement of the so-called weak form market efficiency hypothesis, which maintains that the entire history of a stock is summed up in its present price future movements depend only on new information and on changes in sentiment or the environment. People who believe in charts or concepts such as momentum for predicting stock prices clearly do not believe in this hypothesis in consequence, they should not believe in the results of...

Example A stock price process

Consider a stock that pays no dividends, has an expected return of 10 per annum, and volatility of 20 per annum. If the current price is 100, what is the process for the change in the stock price over the next week What if the current price is 10 The process for the stock price is where e is a random draw from a standard normal distribution. If the interval is one week, or At 1 52 0.01923, the process is AS 100(0.001923 + 0.027735 x e). With an initial stock price at 100, this gives AS 0.1923 + 2.7735e. With an initial stock price at 10, this gives AS 0.01923 + 0.27735e. The trend and volatility are scaled down by a factor of ten._ This model is particularly important because it is the underlying process for the Black-Scholes formula. The key feature of this distribution is the fact that the volatility is proportional to S. This ensures that the stock price will stay positive. Indeed, as the stock price falls, its variance decreases, which makes it unlikely to experience a large...

Properties Of Stock Price Distribution

3.2 PROPERTIES OF STOCK PRICE DISTRIBUTION (iii) Variance and Volatility xT is a stochastic variable with mean mT and variance o2T. T is measured in units of a year and o is referred to as the (annual) volatility of the stock. The reader would be quite right to comment that o should be called the volatility of the logarithm of the stock price but the two are closely related and for most practical purposes, the same. To see this, consider a small time interval 6T (maybe a day or a week) and write S T - S0 6S. Then In practical terms this means that if we estimate volatility from historical stock price data, measuring either daily or weekly price movements, then we get more or less the same result by using either the stock prices themselves or their logarithms. However, these two measures are likely to produce appreciably different results if we use quarterly data. has filled many textbooks but for the moment, it is enough just to understand the big picture. Wt is said to describe a...

The Nasdaq Stock Market

The National Association of Securities Dealers (NASD) is a self-regulatory body that licenses brokers and oversees trading practices. The computerized network used by the NASD is known as the NASD Automated Quotation System, or Nasdaq. Nasdaq started as just a quotation system, but it has grown to become an organized securities market with its own listing requirements. Nasdaq lists about 5,000 stocks, although not all trade through the same Nasdaq system. For example, the Nasdaq National Market lists the larger Nasdaq stocks, such as Microsoft and Intel, while the Nasdaq SmallCap Market lists smaller companies with the potential for high growth. Nasdaq also operates the Nasdaq OTC Bulletin Board, which lists quotes for stock that is registered with the Securities Exchange Commission (SEC) but that is not listed on any exchange, usually because the company is too small or too unprofitable.4 Finally, Nasdaq operates the Pink Sheets, which provide quotes on companies that are not...

How Common Stocks Are Traded

The NYSE is not the only stock market in the United States. For example, many stocks are traded over the counter by a network of dealers, who display the prices at which they are prepared to trade on a system of computer terminals known as NASDAQ (National Association of Securities Dealers Automated Quotations System). If you like the price that you see on the NASDAQ screen, you simply call the dealer and strike a bargain. The prices at which stocks trade are summarized in the daily press. Here, for example, is how The Wall Street Journal recorded the day's trading in GE on July 2, 2001 The Wall Street Journal also provides three other facts about GE's stock. GE pays an annual dividend of .64 a share, the dividend yield on the stock is 1.3 percent, and the ratio of the stock price to earnings (P E ratio) is 38. We will explain shortly why investors pay attention to these figures.

How Common Stocks Are Valued

CHAPTER 4 The Value of Common Stocks 61 At first sight this statement may seem surprising. When investors buy stocks, they usually expect to receive a dividend, but they also hope to make a capital gain. Why does our formula for present value say nothing about capital gains As we now explain, there is no inconsistency.

Reflexivity In The Stock Market

In trying to develop a theory of reflexivity, I shall start with the stock market. For one thing, it is the market I am most familiar with I have been a professional investor for more than twenty-five years. For another, the stock market provides an excellent laboratory for testing theories changes are expressed in quantitative terms and the data are easily accessible. Even the participants' views are usually available in the form of brokers' reports. Most important, I have actually tested my theory in the stock market and I have some interesting case studies to present. As I mentioned in the introduction, I did not develop my ideas on reflexivity in connection with my activities in the stock market. The theory of reflexivity started out as abstract philosophical speculation and only gradually did I discover its relevance to the behavior of stock prices. I was singularly unsuccessful in formulating my theory at the level of abstraction at which I conceived it my failure as a...

What Ethical Considerations Might Enter Into Decisions That Result In Cash Flow And Stock Price Effects That Are Less

PI-13 ETHICS PROBLEM What does it mean to say that managers should maximize shareholder wealth subject to ethical constraints What ethical considerations might enter into decisions that result in cash flow and stock price effects that are less than they might otherwise have been

Crash Course in Investing in Stocks

Most people think of the stock market when it comes to investing. This is probably because it has been around the longest and is the most talked about, not only on Wall Street, but Main Street. It can also be extremely profitable. Look back to 1987 where, in just one month's time between July and August, the Dow Jones Industrial Average soared 11 percent. Then came Black Monday, October 19, 1987, when the Dow fell more than 500 points, losing more than 22 percent of its value in a single day. . Treasury bonds, those debt obligations issued by Uncle Sam, have been more volatile (that is, riskier) than a portfolio of 90 percent bonds and 10 percent common stocks. Stocks held alone are riskier than bonds held alone (remember the asset allocation, spread the risk around), but through the magic of diversification, you can add some stock to an all-bond portfolio and actually reduce the portfolio's risk. Since 1926, the volatility of an 80 percent bond and 20 percent stock portfolio has been...

Understand the psychology of selecting stocks

You only go to parties when you've just made a sweet deal in the stock market. If you couldn't tell others of your shrewd stock picks and your latest killing in the market, there'd be little point to owning securities. While the thought has, hopefully, never crossed your mind of sending copies of a brokerage statement out to friends and relatives, you've been known on more than a few occasions to offer unsolicited stock tips and investment advice.

Calculating the Cost of Preferred Stock

Preferred stock shares some of the characteristics of debt - the preferred dividend is pre-specified at the time of the issue and is paid out before common dividend -- and some of the characteristics of equity - the payments of preferred dividend are not tax deductible. If preferred stock is viewed as perpetual, the cost of preferred stock can be written as follows kps Preferred Dividend per share Market Price per preferred share This approach assumes that the dividend is constant in dollar terms forever and that the preferred stock has no special features (convertibility, callability etc.). If such special features exist, they will have to be valued separately to come up with a good estimate of the cost of preferred stock. In terms of risk, preferred stock is safer than common equity but riskier than debt. Consequently, it should, on a pre-tax basis, command a higher cost than debt and a lower cost than equity. Illustration 4.13 Calculating the Cost Of Preferred Stock Disney and...

Common Stock Theory of Investment

The research demonstrating the superiority of stocks became known as the common stock theory of investment.15 Smith himself was careful to not overstate his findings. He wrote Over a period of years the principal value of a well-diversified holding of common stocks of representative corporations in essential industries tends to increase in accordance with the operation of compound interest. . . . Such stock holding may be relied upon over a term of years to pay an average income return on such increasing values of something more than the average current rate on commercial paper.16 Yet Chelcie C. Bosland, a professor of economics at Brown University in the 1930s, claimed that the common stock theory was often misused to justify any investment in stocks no matter what the price. Bosland stated The purchase of common stocks after 1922 was more likely to result in profit than in loss. Even though this was largely a cyclical up-swing, many believed that it was a vindication of the theory...

Stocks and the Stock Market

Firms issue shares of common stock to the public when they need to raise money.1 stock, and common stock interchangeably, as we do shareholders and reading the stock market listings When you read the stock market pages in the newspaper, you are looking at the secondary market. Figure 5.2 is an excerpt from The Wall Street Journal of NYSE trading on February 25, 2000. The highlighted bar in the figure highlights the listing for PepsiCo.2 The two numbers to the left of PepsiCo are the highest and lowest prices at Trading volume in major world stock markets, 1998 Trading volume in major world stock markets, 1998 Stock Markets Stock Markets price-earnings (p e) multiple Ratio of stock price to earnings per share. which the stock has traded in the last 52 weeks, 41V2 and 30Vs, respectively. That's a reminder of just how much stock prices fluctuate. The price-earnings (P E) multiple for Pepsi is reported as 25. This is the ratio of the share price to earnings per share. The P E ratio is a...

Example 41 Computing Portfolio Weights for a Two Stock Portfolio

In Example 4.1, both portfolio weights are positive. However, investors can sell short certain securities, which means that they can sell investments that they do not currently own. To sell short common stocks or bonds, the investor must borrow the securities from someone who owns them. This is known as taking a short position in a security. To close out the short position, the investor buys the investment back and returns it to the original owner. The Mechanics of Short Sales of Common Stock An Illustration

Valuation of Common Stock

When you buy a share of common stock, it is reasonable to assume that the price you pay reflects what you expect to receive from it in the form of a return on your investment. What you receive are cash dividends in the future. How can we relate that return to the value of a share of common stock The value of a share of stock should be equal to the present value of all the future cash flows you expect to receive from that share Price of a share of common stock Because common stock never matures, today's value is the present value of an infinite stream of cash flows. And also, common stock dividends are not fixed, as in the case of preferred stock. Not knowing the amount of the dividends or even if there will be future dividends makes it difficult to determine the value of common stock. So what are we to do Well, we can attempt to determine the valuation of common stock by looking at its current dividend and making assumptions about any future dividends it may pay. We will describe the...

Common Stock Valuation

A share of common stock is more difficult to value in practice than a bond, for at least three reasons. First, with common stock, not even the promised cash flows are known in advance. Second, the life of the investment is essentially forever, since common stock has no maturity. Third, there is no way to easily observe the rate of return that the market

Returns on Common Stock

We can calculate the return on an investment in common stocks just as we did the internal rate of return in the preceding example. The return on stock is comprised of two components (1) the appreciation (or depreciation) in the market price of the stock the capital yield and (2) the return in the form of dividends the dividend yield Let's first ignore dividends. The return on common stock over a period of time where there are no dividends is the change in the stock's price divided by the beginning share price To simplify our analysis, let's ignore our stockbroker's commission, though we will discuss these costs later in this chapter. Suppose we bought 100 shares of Internet.com common stock at the end of 1997 at 351 4. We have invested 100 x 35.25 3,525 in Internet.com stock. During 1997, Internet.com paid 0.43 per share in dividends, so we earned 43.00 in dividends. If we sold the Internet.com shares at the end of 1997 for 43 ( 43.00 per share, or 4,300.00 for all 100 shares), what...

Valuation Of Preferred Stock

The value of preferred stock is the present value of all future dividends. If a share of preferred stock has a 5 dividend (based on a 100 par value), paid at the end of each year, today's price is the present value of the stream of 5's forever, discounted at the rate rp Present value of preferred stock If the discount rate is 10 , the present value of the preferred stock is 50. That is, investors are willing to pay 50 today for the promised stream of 5 per year since they consider 10 to be sufficient compensation for both the time value of money and the risk associated with the perpetual stream of 5s. rate, (i.e., the required rate of return on the preferred stock). Then We can make some generalizations about the value of preferred stock The greater the dividend rate, the greater the value of a share of preferred stock. The greater the required rate of return the discount rate the lower value of a share of preferred stock. Here is another example of valuing a share of preferred stock....

The Market for Common Stock

Some companies are so small that their common stocks are not actively traded they are owned by only a few people, usually the companies' managers. Such firms are said to be privately owned, or closely held, corporations, and their stock is called closely held stock. In contrast, the stocks of most larger companies are owned by a large number of investors, most of whom are not active in management. Such companies are called publicly owned corporations, and their stock is called publicly held stock. Note that http finance. yahoo.com provides an easy way to find stocks meeting specified criteria. Under the section on Stock Research, select Stock Screener. To find the largest companies in terms of market value, for example, go to the pull-down menu for Market Cap and choose a Minimum of 100 billion. Then click the Find Stocks button at the bottom, and it will return a list of all companies with market capitalizations greater than 100 billion. A recent study found that institutional...

Effect on Stock Prices

Interest rates indirectly impact stock prices through their effect on corporate profits. The payment of interest is a cost to companies - the higher the level of interest rates, the lower the level of corporate profits (other factors held constant). Interest rates affect the level of economic activity which, in turn, affects corporate profits. The effect of interest rates on corporate profits is more important for individual companies, especially those with high debt levels. The direct competition for capital has a more widespread effect on the general stock price level for the entire economy.

Preferred Stock Features

Preferred stock differs from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that the holders of the preferred shares must receive a dividend (in the case of an ongoing firm) before holders of common shares are entitled to anything. Preferred stock is a form of equity from a legal and tax standpoint. It is important to note, however, that holders of preferred stock sometimes have no voting privileges. Dividends payable on preferred stock are either cumulative or noncumulative most are cumulative. If preferred dividends are cumulative and are not paid in a particular year, they will be carried forward as an arrearage. Usually, both the accumulated (past) preferred dividends and the current preferred dividends must be paid before the common shareholders can receive anything. Unpaid preferred dividends are not debts of the firm. Directors elected by the...

Dynamics of Stock Prices

The price of stock at time t will be denoted by S(t). It is assumed to be strictly positive for all t. We take t 0 to be the present time, S(0) being the current stock price, known to all investors. The future prices S(t) for t > 0 remain unknown, in general. Mathematically, S(t) can be represented as a positive random variable on a probability space Q, that is, The current stock price S(0) known to all investors is simply a positive number, but it can be thought of as a constant random variable. The unknown future prices S(t) for t > 0 are non-constant random variables. This means that for each t > 0 there are at least two scenarios G Q such that S(t,u> ) S(t,w).

Actual Stock Prices and Returns

Our discussion thus far has focused on expected stock prices and expected rates of return. Anyone who has ever invested in the stock market knows that there can be, and there generally are, large differences between expected and realized prices and returns. 17Market efficiency also has important implications for managerial decisions, especially those pertaining to common stock issues, stock repurchases, and tender offers. Stocks appear to be fairly valued, so decisions based on the premise that a stock is undervalued or overvalued must be approached with caution. However, managers do have better information about their own companies than outsiders, and this information can legally be used to the companies' (but not the managers') advantage. Think of a graph with stock price on the vertical axis and years on the horizontal axis. A stock's fundamental value might be moving up steadily over time as it retains and reinvests earnings. However, its actual price might fluctuate about the...

Investing in International Stocks

As noted in Chapter 3, the U.S. stock market amounts to only about 40 percent of the world stock market, and this is prompting many U.S. investors to hold at least some foreign stocks. Analysts have long touted the benefits of investing overseas, arguing that foreign stocks both improve diversification and provide good growth opportunities. For example, after the U.S. stock market rose an average of 17.5 percent a year during the 1980s, many analysts thought that the U.S. market in the 1990s was due for a correction, and they suggested that investors should increase their holdings of foreign stocks. To the surprise of many, however, U.S. stocks outperformed foreign stocks in the 1990s they gained about 15 percent a year versus only 3 percent for foreign stocks. Figure 5-7 shows how stocks in different countries performed in 2001. The number on the left indicates how stocks in each country performed in terms of its local currency, while the right numbers show how the country's stocks...

The Dollar Versus The Stock Market

It stands to reason since both the dollar and the stock market are influenced by interest rate trends (as well as inflation) that there should be a direct link between the dollar and stocks. The relationship between the dollar and the stock market exists but is often subject to long lead times. A rising dollar will eventually push inflation and interest rates lower, which is bullish for stocks. A falling dollar will eventually push stock prices lower because of the rise in inflation and interest rates. However, it is an oversimplification to say that a rising dollar is always bullish for stocks, and a falling dollar is always bearish for equities. Figure 6.11 shows the dollar dropping from 1985 through 1987, during which time stocks continued to advance. Stocks didn't actually sell off sharply until the second half of 1987, more than two years after the dollar peaked. Going back to the beginning of the decade, the dollar bottomed in 1980, two years before the 1982 bottom in stocks. In...

Planned Obsolescence Has A Product That Will Be In Vogue For 3 Years At Which Point The Firm Will Close Up Shop And

What information about company stocks is regularly reported in the financial pages of the newspaper Firms that wish to raise new capital may either borrow money or bring new partners into the business by selling shares of common stock. Large companies usually arrange for their stocks to be traded on a stock exchange. The stock listings report the stock's dividend yield, price, and trading volume. How can one calculate the present value of a stock given forecasts of future dividends and future stock price Unlike the fixed interest payments that the firm promises to bondholders, the dividends that are paid to stockholders depend on the fortunes of the firm. That's why a company's common stock is riskier than its debt. The return that investors expect on any one stock is also the return that they demand on all stocks subject to the same degree of risk. The present value of a stock equals the present value of the forecast future dividends and future stock price, using that expected return...

Options Prices And Stock Price Movements

Up to this point, we have studied the way in which four factors constrain call and put prices. These factors are the stock price, the exercise price, the time remaining until expiration, and the interest rate. Even with these four factors, we cannot say exactly what the option price must be before expiration. There is a fifth factor to consider stock price movements before expiration. If we consider a stock with options on it that expire in six months, we know that the stock price can change thousands of times before the option expires. Further, for two stocks, the pattern of changes and the volatility of the stock price changes can differ dramatically. However, if we can develop a model for understanding stock price movements, we can use that model to specify what the price of an option must be. We now make a drastic, but temporary, simplifying assumption. Between the current moment and the expiration of an option, we assume that the stock price will rise by 10 percent or fall by 10...

Peanut Company Acquired 80 Of The Common Stock Of

Problem 4-13 (LO 2, 3, 6) 80 , sophisticated equity, several excess distributions, merchandise, equipment sales. (This is the same as Problem 4-11 except for use of the sophisticated equity method.) On January 1, 20X1, Peanut Company acquired 80 of the common stock of Sam Company for 200,000. On this date, Sam had total owners' equity of 200,000. During 20X1 and 20X2, Peanut has appropriately accounted for its investment in Sam using the sophisticated equity method. Common Stock, Peanut Company Common Stock, Sam Company On January 1, 20X1, Purple Company acquired Simple Company. Purple paid 300,000 for 80 of Simple's common stock. On the date of acquisition, Simple had the following balance sheet Common stock

The Cost of Preferred Stock

The cost of preferred stock is the cost associated with raising one more dollar of capital by issuing shares of preferred stock. As explained in Chapter 17, preferred stock may or may not have a maturity. Preferred stock without a maturity date is called perpetual preferred stock. Consider perpetual preferred stock with a fixed dividend rate, where the dividend is expressed as a percentage of the par value of a share.2 The value of this type of preferred stock is the present value of all future dividends to be received by the investor. If a share of preferred stock has a 5 dividend (based on a 100 par value) paid at the end of each year, the value of the stock today is the present value of the stream of 5's forever Present value of preferred stock + + + Present value of preferred stock 5 Present value of preferred stock - 5- 50 Let's rephrase this relationship, letting Pp indicate today's price, which is the present value of the preferred stock, Dp indicate the perpetual dividend per...

Commodities Versus Stocks

Figure 6.14 compares the CRB Index to the Dow Industrial Average from 1985 through the third quarter of 1989. The chart shows that stocks and commodities sometimes move in opposite directions and sometimes move in tandem. Still, some general conclusions can be drawn from this chart (and from longer-range studies), which reveals a rotational rhythm that flows through both markets. A rising CRB Index is eventuallyheaxish for stocks. A falling CRB Index is eventuallyhullish for stocks. The inflationary impact of rising commodity prices (and rising interest rates) will combine to push stock prices lower (usually toward the end of an economic expansion). The impact of falling commodity prices (and falling interest rates) will eventually begin to push stock prices higher (usually toward the latter part of an economic slowdown). The usual sequence of events between the two markets will look something like this A peak in commodity prices will be followed in time by a bottom in stock prices....

Gold And The Stock Market

Usually when the conversation involves the relative merits of investing in commodities (tangible assets) versus stocks (financial assets), the focus turns to the gold market. The gold market plays a key role in the entire intermarket story. Gold is viewed as a safe haven during times of political and financial upheavals. As a result, stock market investors will flee to the gold market, or gold mining shares, when the stock market is in trouble. Certainly, gold will do especially well relative to stocks during times of high inflation (the 1970s for example), but will underperform stocks in times of declining inflation (most of the 1980s).

The Cost of Common Stock

The cost of common stock is the cost of raising one more dollar of common equity capital, either internally (from earnings retained in the firm)3 or externally (by issuing new shares of common stock). There are costs associated with both internally and externally generated capital. The only difference between the cost of internally and externally generated funds is the cost of issuing new common stock. The cost of internally generated funds is the opportunity cost of those funds what shareholders could have earned on these funds. But the cost of externally generated funds (that is, funds from selling new shares of stock) includes both the sum of the opportunity cost and cost of issuing the new stock. The cost of issuing common stock is difficult to estimate because of the nature of the cash flow streams to common shareholders. Common shareholders receive their return (on their investment in the stock) in the form of dividends and the change in the price of the shares they own. The...

Cost of Common Stock Using the Dividend Valuation Model

In Chapter 9, we reviewed the dividend valuation method (DVM) for valuing common stock. The DVM states that the price of a share of stock is the present value of all its future cash dividends, where the future dividends are discounted at the required rate of return on equity, r. If these dividends are constant forever (similar to the dividends of perpetual preferred stock, as we just covered), the cost of common stock is derived from the value of a perpetuity. Let D represent the constant dividend per share of common stock that is expected next period and each period after that forever P0, the current price of a share of stock and re, the cost of common stock. The current price of a share of common stock is However, common stock dividends do not usually remain constant. It's typical for dividends to grow at a constant rate. Let D0 indicate this period's dividend. If dividends grow at a constant rate, g, forever, the present value of the common stock is the present value of all future...

Cost of Preferred Stock r

A number of firms, including NCC, use preferred stock as part of their permanent financing mix. Preferred dividends are not tax deductible. Therefore, the company bears their full cost, and no tax adjustment is used when calculating the cost of preferred stock. Note too that while some preferreds are issued without a stated maturity date, today most have a sinking fund that effectively limits their life. Finally, although it is not mandatory that preferred dividends be paid, firms generally have every intention of doing so, because otherwise (1) they cannot pay dividends on their common stock, (2) they will find it difficult to raise additional funds in the capital markets, and (3) in some cases preferred stockholders can take control of the firm. The component cost of preferred stock used to calculate the weighted average cost of capital, rps, is the preferred dividend, Dps, divided by the net issuing price, Pn, which is the price the firm receives after deducting flotation costs...

Example IBM Preferred Stock

As of April 2001, the depositary shares were trading at 25.4, within a narrow 52-week trading range of 25.00, 26.25 . Using the valuation formula for a consol, the shares trade at an implied yield of 7.38 . The total market capitalization of the IBM-A shares amounts to approximately 260 million. In comparison, the market value of the common stock is 214,602 million, which is more than 800 times larger.

Expected Rate of Return on a Constant Growth Stock

10The rs value in Equation 5-2 is a required rate of return, but when we transform to obtain Equation 5-4, we are finding an expected rate of return. Obviously, the transformation requires that rs rs. This equality holds if the stock market is in equilibrium, a condition that will be discussed later in the chapter. Suppose this analysis had been conducted on January 1, 2003, so P0 23 is the January 1, 2003, stock price, and D1 1.242 is the dividend expected at the end of 2003. What is the expected stock price at the end of 2003 We would again apply Equation 5-2, but this time we would use the year-end dividend, D2 D1 (1 + g) 1.242(1.08) 1.3414 The dividend yield for 2005 could also be calculated, and again it would be 5.4 percent. Thus, for a constant growth stock, the following conditions must hold 2. The stock price is expected to grow at this same rate.

Delta The Sensitivity to Stock Price Changes

The Greek letter delta (A) is commonly used in mathematics to represent a change in something. In finance, delta is the change in the value of the derivative security with respect to movements in the stock price, holding everything else constant. The delta of the option is the derivative of the option's price with respect to the stock price, dc0 dS0 for a call, dp0 dS0 for a put. The derivative of the right-hand side of the Black-Scholes formula, equation (8.3), with respect to S0, the delta of the call option, is N(d1). (See exercise 8.4.) Because N(d1) is a probability, the number of shares needed to track the option lies between zero and one. In addition, as time elapses and the stock price changes, d1 changes, implying that the number of shares of stock in the tracking portfolio needs to change continuously. Thus, the tracking of the option using the Black-Scholes Model, like that for the binomial model, requires dynamically changing the quantities of the stock and risk-free bond...

Value Stocks Offer Higher Returns Than Growth Stocks

The second dimension along which stocks are classified is by valuation that is, factors relating the price of the stock relative to some fundamental metric of firm worth, such as dividends, earnings, book values, and cash flows. Like small-cap stocks, Fama and French determined that stocks that were cheap relative to these fundamentals had higher returns than would be predicted by the capital asset pricing model. Stocks whose prices are low relative to these fundamentals are called value stocks, while those with prices high relative to these fundamentals are called growth stocks. Prior to the 1980s, value stocks were often called cyclical stocks because low-P-E stocks were often found in those industries whose profits were closely tied to the business cycle. With the growth of style investing, equity managers that specialized in these stocks were uncomfortable with the cyclical moniker and greatly preferred the term value. Value stocks generally occur in such industries as oil, motor,...

Stocks and Stock Markets

Stock represents ownership of a corporation. The stockholders, or shareholders, are the holders of the stock. There are different types of stock, but in this book we study common stock.1 1 Owners of common stock have voting rights and are entitled to the earnings of the company after all obligations are paid. The first stock market in the United States originated in Philadelphia in 1790. It eventually became known as the Philadelphia Stock Exchange. The New York Stock Exchange (NYSE), initiated in 1792, is the largest stock exchange in the world. As many as one billion shares are traded during a single day on the NYSE. Trading on this exchange occurs auction style. The buyers and sellers have the option of sending bids and offers to the exchange and accepting the bids and offers from others at the exchange. Stock is sold to the highest bidder and bought at the lowest offer. The NASDAQ (National Association of Securities Dealers Automatic Quotation System) is another major United...

Mike Is Searching For A Stock To Include In His Current Stock Portfolio. He Is Interested In Apple Inc. He Has Been

iW-i Rate of return, standard deviation, coefficient of variation Mike is searching for a stock to include in his current stock portfolio. He is interested in Apple Inc. he has been impressed with the company's computer products and believes Apple is an innovative market player. However Mike realizes that any time you consider a so-called high-tech stock, risk is a major concern. The rule he follows is to include only securities with a coefficient of variation of returns below 0.90.

Stock Market Volatility

Table 13-6 compares the RiskMetrics volatility forecasts for a group of 31 stock markets. The selected indices are those most recognized in each market, for example the S& P 500 in the US, Nikkei 225 in Japan, and FTSE-100 in Britain. Most of these have an associated futures contract, so positions can be taken in cash markets or, equivalently, in futures. Nearly all of these indices are weighted by market capitalization. Stock Market

Cost of Newly Issued Common Stock or External Equity re

The cost of new common equity, re, or external equity, is higher than the cost of equity raised internally by reinvesting earnings, rs, because of flotation costs involved in issuing new common stock. What rate of return must be earned on funds raised by selling new stock to make issuing stock worthwhile To put it another way, what is the cost of new common stock The answer for a constant growth stock is found by applying this formula Investors require a return of rs 13.4 on the stock.15 However, because of flotation costs the company must earn more than 13.4 percent on the net funds obtained by selling stock if investors are to receive a 13.4 percent return on the money they put up. Specifically, if the firm earns 14 percent on funds obtained by issuing new stock, then earnings per share will remain at the previously expected level, the firm's expected dividend can be maintained, and, as a result, the price per share will not decline. If the firm earns less than 14 percent, then...

Stock Market Indexes Pricing and Risk

Stock market indexes are used to compute an average price for groups of stocks. A stock market index attempts to mirror the performance of the group of stocks it represents through the use of one number, the index. Indexes may represent the performance of all stocks in an exchange or a smaller group of stocks, such as an industrial or technological sector of the market. In addition, there are foreign and international indexes. 10.1 Stock Market Indexes In this section we discuss how Dow Jones, Standard and Poor's, NASDAQ, and Value Line calculate their indexes. These indexes depend on stock price, number of shares issued, stock splits, and dividends. However, these are not independent. For example, if a 50 stock with 100 shares issued splits two-for-one, then after the split there are 200 shares, each worth 25. If a 50 stock pays 10 stock dividend (worth 5 a share), then after the dividend the stock is worth 50 1.1 45.45. The oldest and most quoted stock market index is the Dow Jones...

The Nature Of Growth And Value Stocks

Therefore, a firm in the technology sector, which is considered to be an industry with high growth prospects, could actually be classified as a value stock if it is out of favor with investors and sells for a low price relative to fundamentals. Alternatively, a promising auto manufacturer in a mature industry with limited growth potential could be classified a growth stock if its stock is in favor with investors and priced high relative to fundamentals. In fact, over time many firms and even industries are alternately characterized as value or growth as their market price fluctuates.

Investing in individual stocks

As a financial counselor, I noticed a distinct difference between the sexes on this issue. Perhaps because of the differences in how people are raised, testosterone levels, or whatever, men tend to have more of a problem swallowing their egos and admitting that they're better off not selecting their own individual securities. Maybe the desire to be a stock picker is genetically linked to not wanting to ask for directions Investing in individual stocks entails numerous drawbacks and pitfalls You're less likely to diversify. Unless you have tens of thousands of dollars to invest in different stocks, you probably can't cost-effectively afford to develop a diversified portfolio. For example, when you're investing in stocks, you should hold companies in different industries, different companies within an industry, and so on. By not diversifying, you unnecessarily add to your risk. Of course, you may find some people (with a vested interest) who try to convince you that picking your own...

Interpreting Typical Stock Market Betas

The market beta is the best measure of diversification help for an investor who holds the stock market portfolio and considers adding just a little of your firm's project. From your perspective as a manager seeking to attract investors from everywhere in the market, this is a reasonable assumption. Recall that we assume that your investors are diversified, holding the stock market portfolio. To get your market investors to like a 10 million project, you just need the average investor to want to buy 10 million divided by about 10 trillion the stock market capitalization , which is 1 1,000,000 of their portfolios. For your investors, your corporate project is just a tiny addition to their market portfolios. You can look up the market betas of publicly traded stocks on many financial websites. Table 12.2 lists the betas of some randomly chosen companies in January 2004. Typical company betas are in the range of around 0 to about 2.5. A beta above 1 is considered risk-increasing for an...

Common Stock 200 000 Retained Earnings 190 000

On January 1, 20X1, Press Company acquired 80 of Sabre Company's common stock for 450,000. On the date of the acquisition, Sabre had the following balance sheet 60,000 Common stock 10,000 Problem 5-11 (LO 5) 80 , equity, financing lease, merchandise. Refer to the preceding facts for Press's acquisition of Sabre common stock. Press uses the simple equity method to account for its investment in Sabre. On January 1, 20X2, Press held merchandise acquired from Sabre for 10,000. During 20X2, Sabre sold 40,000 worth of merchandise to Press. Press held 12,000 of this merchandise at December 31, 20X2. Press owed Sabre 6,000 on December 31 as a result of this intercompany sale. Sabre has a gross profit rate of 25 . Common Stock Problem 5-12 (LO 5) 80 , equity, financing lease, merchandise, later year. Refer to the preceding facts for Press' acquisition of Sabre common stock. Press uses the simple equity method to account for its investment in Sabre. On January 1, 20X3, Press held merchandise...

Reading The Stock Market Listings

When you read the stock market pages in the newspaper, you are looking at the secondary market. Figure 3.11 is an excerpt from The Wall Street Journal of NYSE trading on February 25, 2000. The highlighted bar in the figure highlights the listing for PepsiCo.2 The two numbers to the left of PepsiCo are the highest and lowest prices at Trading volume in major world stock markets, 1998 Trading volume in major world stock markets, 1998 Stock Markets Stock Markets PRICE-EARNINGS (P E) MULTIPLE Ratio of stock price to earnings per share. which the stock has traded in the last 52 weeks, 41V2 and 301 8, respectively. That's a reminder of just how much stock prices fluctuate. The price-earnings (P E) multiple for Pepsi is reported as 25. This is the ratio of the share price to earnings per share. The P E ratio is a key tool of stock market analysts. For example, low P E stocks are sometimes touted as good buys for investors. We will have more to say about P E later in this material. Stock...

Using the PE ratio to judge company market value stock price

In addition to comparing two companies, you should compare the P E calculation to the industry in which the companies fall. Doing so allows you to gauge stock price or market value not only for the companies whose annual reports you're analyzing but also for other companies in the same business. Stock prices are set by the market based solely on the price at which someone is willing to sell a stock and the price at which someone is willing to buy a stock. Be careful when you see P Es creeping above their historical averages. Usually you're encountering a sign that a correction is looming on the horizon, which will bring stock prices back down to realistic levels.

The Lognormal Property Of Stock Prices

A variable has a lognormal distribution if the natural logarithm of the variable is normally distributed. It has just been shown that the model of stock price behavior developed in Chapter 9 implies that where St is the stock price at a future time T S is the stock price at the current time, and < j> (m, s) denotes a normal distribution with mean m and standard deviation s. From the properties of the normal distribution, it follows from Equation (10.6) that This shows that St has a lognormal distribution. The standard deviation of In St is proportional to JT - t. This means that our uncertainty about the logarithm of the stock price, as measured by its standard deviation, is proportional to the square root of how far ahead we are looking. Consider a stock with an initial price of 40, an expected return of 16 per annum, and a volatility of 20 per annum. From Equation (10.7), the probability distribution of the stock price, St, in 6 months' time is given by The value of G at time t...

In words the value of a stock is the present value of the dividends it will pay over the investors horizon plus the

Does this mean that investors of different horizons will all come to different conclusions about the value of the stock No Regardless of the investment horizon, the stock value will be the same. This is because the stock price at the horizon date is determined by expectations of dividends from that date forward. Therefore, as long as the investors are consistent in their assessment of the prospects of the firm, they will arrive at the same present value. Let's confirm this with an example. Take Blue Skies. The firm is growing steadily and investors expect both the stock price and the dividend to increase at 8 percent per year. Now consider three investors, Erste, Zweiter, and Dritter. Erste plans to hold Blue Skies for 1 year, Zweiter for 2, and Dritter for 3. Compare their payoffs Remember, we assumed that dividends and stock prices for Blue Skies are expected to grow at a steady 8 percent. Thus DIV, 3 x 1.08 3.24, DIV3 3.24 x 1.08 3.50, and so on. All agree the stock is worth 75 per...

British And Us Stock Markets

Figures 8.6 through 8.10 provide a visual comparison of the British and the U.S. stock markets from 1985 into the beginning of 1990. Although the charts are not exactly alike, there is a strong visual correlation. Given their strong historical ties, it can be seen why it's a good idea to keep an eye on both. As is often the case with intermarket comparisons, clues to one market's direction can often be found by studying the chart of a related market. I've already alluded to the tendency of the British market to lead the U.S. stock market at tops. In Figure 8.6, three examples of this phenomenon can be seen in the three peaks that took place in early 1986, late 1987, and late 1989. (Going back a bit further in time, U.S. stock market peaks in 1929, 1956, 1961, 1966, 1972, and 1976 were preceded by tops in British stocks.)

Us And Japanese Stock Markets

Figure 8.11 through 8.15 provide a comparison of the American market (utilizing the Dow Jones Industrial Average) and the Japanese market (utilizing the Nikkei 225 Stock Average). The fit between these two markets isn't as tight as that between the American and British markets. Still, there's no question that they have an impact on one another. Figure 8.11 demonstrates the global bull market from 1985 through 1989 as reflected in the world's two largest stock markets.

Crosslisted stocksan application of the oneprice principle

The one-good one-price principle also has applications in stock markets. Here's an example IBM stock is traded both on the New York Stock Exchange (NYSE) and on the Pacific Stock Exchange (PSE). When both exchanges are open, the prices of IBM stock are basically There's more to this than meets the eye The NYSE opens before the PSE, but the PSE stays open later. This means that information about IBM which arrives late in the day will be incorporated in the PSE stock price but will hit the NYSE price only the next morning. In some cases this phenomenon is even more extreme for example, there's a large group of Israeli shares which is traded both in Tel-Aviv and on the Nasdaq in the United States. The trading overlap between the two markets is only 1 hour per day (between 9 30 and 10 30 am Eastern time, both Nasdaq and Tel-Aviv are open after this Tel-Aviv closes and all trading in the duallisting stocks is on the Nasdaq ). During this trading overlap, cross-listed stocks have the same...

Blackscholes And Noarbitrage Pricing 821 The stock price dynamics

The Black-Scholes model for pricing European equity options assumes the stock price has the following dynamics From Ito's lemma, the logarithm of the stock price has the following dynamics which means that the stock price has a lognormal distribution or the logarithm of the stock price has a normal distribution. In discrete time

New trends in the stock markets

In recent years, a number of new trends have begun to emerge in the stock markets around the world (1) alliance, (2) crosslisting, and (3) concentration. Stock market alliances There are some 150 stock exchanges in the world. Within the past 10 years, these stock exchanges have scrambled to align with each other. Markets in Paris, Amsterdam, and Brussels have agreed to form Euronext, while a group of Scandinavian markets has agreed to form Norex. Those deals prompted the London Stock Exchange and Frankfurt's Deutsche Bourse to consider a merger into a new market, but that deal fell through in Septem- In addition, these same factors have caused another wave of stock markets becoming publicly traded on the different stock exchanges. In 2001, the London Stock Exchange and the Deutsche Bourse went public and are traded on their markets, while the Toronto Stock Exchange and Spain's four regional stock exchanges went public in 2002. In December 2002, the Chicago Mercantile Exchange, the...

Application The aggregate stock market

Researchers studying the aggregate U.S. stock market have identified a number of interesting facts about its behavior. Three of the most striking are The Equity Premium. The stock market has historically earned a high excess rate of return. For example, using annual data from 1871-1993, Campbell and Cochrane (1999) report that the average log return on the S& P 500 index is 3.9 higher than the average log return on short-term commercial paper. To see this, consider the following endowment economy, which we come back to a number of times in this section. There are an infinite number of identical investors, and two assets a risk-free asset in zero net supply, with gross return R j between time t and t + 1, and a risky asset - the stock market - in fixed positive supply, with gross return Rt + between time t and t + 1. The stock market is a claim to a perishable stream of dividends D , where

Simulating Stock Prices

In most of finance, especially in analysis of derivatives, we assume that asset prices are unpredictable and follow a geometric Brownian motion. Most people find it difficult to grasp exactly what this means, but having a good understanding of it is essential to do any work with derivatives. In this chapter we will build a few models that will help you understand exactly what a geometric Brownian motion is, what it implies for future prices of stocks, and how we can use it to simulate stock prices. Such simulations form the basis for Monte Carlo simulations, which is one of the three approaches used widely to price derivatives.

Simple Model for Stock Prices

We can simulate the price of this stock using a coin. We will flip the coin once to represent each day. If the coin comes up heads, we will assume that the stock price goes up by 1 for that day if it comes up tails, the stock price goes down by 1 for that day. Suppose the first coin flip representing the first day is heads. Then the result of our simulation is that the price of the stock will be 21 at the end of the first day. If we get heads again, then the simulated price at the end of the second day will be 22. We can simulate the stock price for as many days as we want by repeating the process, and if we plot our results on a chart (with the day number along the X axis and stock price along the Y axis), we will have one simulated price path. Note that the simulation depends on our model for the stock price and the price path we generated with the first set of coin flips is one of many possible price paths. The number of possible price paths will increase rapidly with the number of...

A2 Estimating the sensitivity of common stock value to stockreturn volatility

I estimate the per-share sensitivity of common stock value to equity risk at December 31, 1993, in two steps ii) Use the implied firm value to estimate the Black-Scholes partial derivative of stock price with respect to a 0.01 change in the annualized standard deviation of stock returns.8 Descriptive statistics for the parameters used to estimate the sensitivity of common stock to stock-return volatility appear in Table 15.6. These parameters are defined as follows Option value per-share price of common stock Table 15.6 Description of parameters used in Black-Scholes computations for common stock The sample consists of 278 CEOs selected uniformly from the 1000 largest firms on Compustat, ranked by market value of equity on December 31, 1988. All data are for 1993. Per-share stock price is the stock price on December 31. 1993. Per-share book value of debt is the book value of liabilities as of December 31, 1993. Per-share market value of assets is per-share stock price plus per-share...

How can stock valuation formulas be used to infer the expected rate of return on a common stock

The present value of a share is equal to the stream of expected dividends per share up to some horizon date plus the expected price at this date, all discounted at the return that investors require. If the horizon date is far away, we simply say that stock price equals the present value of all future dividends per share. This is the dividend discount model. www.ganesha.org invest index.html Links to information useful for valuing securities www.nasdaq.com Information about Nasdaq and Amex-traded stocks www.nyse.com Information about stocks and trading on the New York Stock Exchange How investors value firms www.zacks.com Information and analyses from Zacks Investment Research www.Investools.com Investing tools, links to research reports on public companies and investment newsletters common stock initial public offering (IPO) secondary market dividend 3. Preferred Stock. Preferred Products has issued preferred stock with a 7 annual dividend that will be paid in perpetuity. b. If the...

Stock Prices and Random Walks

What stock market patterns have looked like, do they not Perhaps. Does it make sense to On the other hand, Graphs D, E, and F could actually be representative. On average, each price in the next month is just a tiny bit higher than the previous (i.e., the expected rate of return on stocks is positive), but the important aspect of the D, E, and F graphs is that there is a lot of noise, up or down. Noise is by definition unpredictable, and stock prices must largely be unpredictable, or you could outsmart the stock market. Incidentally, one of these three graphs is a real stock price that I picked at random, while the other two are simulated (as random walks, explained below). Can you detect which one I cannot The real-world price series fits right in with my simulations of patternless day-to-day changes. In fact, if you ever look at graphical representations of stock prices, most will look very much like Graphs D-F and very unlike Graphs A-C. (Solution Graph E is the actual stock price...

Cost of Preferred Stock

The cost of preferred stock is the cost that a company has committed to pay preferred stockholders as a preferred dividend when it issues preferred stock. In the case of nonconvertible, noncallable preferred stock that has a fixed dividend rate and no maturity date (fixed rate perpetual preferred stock), we can use the formula for the value of a preferred stock Pp the current preferred stock price per share Dp the preferred stock dividend per share rp the cost of preferred stock We can rearrange this equation to solve for the cost of preferred stock Therefore, the cost of preferred stock is the preferred stock's dividend per share divided by the current preferred stock's price per share. Unlike interest on debt, the dividend on preferred stock is not tax-deductible by the company therefore, there is no adjustment to the cost for taxes.12 A preferred stock may have a number of features that affect the yield and hence the cost of preferred stock. These features include a call option,...

The Process For Stock Prices

It is tempting to suggest that a stock price follows a generalized Wiener process that is, that it has a constant expected drift rate and a constant variance rate. However, this model fails to capture a key aspect of stock prices. This is that the expected percentage return required by investors from a stock is independent of the stock's price. If investors require a 14 percent per annum expected return when the stock price is 10, then, ceteris paribus, they will also require a 14 percent per annum expected return, when it is 50. Clearly, the constant expected drift-rate assumption is inappropriate and needs to be replaced by the assumption that the expected drift, expressed as a proportion of the stock price, is constant. The latter implies that if S is the stock price, the expected drift rate in S is S for some constant parameter, p. Thus, in a short interval of time, At, the expected increase in S is pS At. The parameter, p, is the expected rate of return on the stock, expressed in...

Between preference shares and convertible debt convertible preferred stocks

Their main characteristics are (1) deep subordination (2) long-dated maturity (3) multiyear dividend interest deferral (4) various common stock conversion features.12 Within the convertible preferred stock category, there are two primary security types Conventional convertible preferred. Typically structured as either perpetual or 30-year preferred stock. Mandatory convertible preferred stock. Short-maturity preferred securities that automatically convert into common stock at maturity.

Corporate Strategy and the Stock Market

There should be a connection between the stock market and capital budgeting. If a firm invests in a project that is worth more than its cost, the project will produce positive NPV, and the firm's stock price should go up. However, the popular financial press frequently suggests that the best way for a firm to increase its share price is to report high short-term earnings (even if by doing so it cooks the books). As a consequence, it is often said that U.S. firms tend to reduce capital expenditures and research and development in order to increase short-term profits and stock prices.1 Moreover, it is claimed that U.S. firms that have valid long-term goals and undertake long-term capital budgeting at the expense of short-term profits are hurt by shortsighted stock market reactions. Sometimes institutional investors are blamed for this state of affairs. By contrast, Japanese firms are said to have a long-term perspective and make the necessary investments in research and development to...

Cost oNeu Issues of Common Stock

Our purpose in finding the firm's overall cost of capital is to determine the aftertax cost of new funds required for financing projects. The cost of a new issue of common stock, r , is determined by calculating the cost of common stock, net of underpricing and associated flotation costs. Normally, for a new issue to sell, it has to be underpriced sold at a price below its current market price, Pq. diluted, thereby justifying a lower share value. Finally, many investors view the issuance of additional shares as a signal that management is using common stock equity financing because it believes that the shares are currently overpriced. Recognizing this information, they will buy shares only at a price below the current market price. Clearly, these and other factors necessitate underpricing of new offerings of common stock. Flotation costs paid for issuing and selling the new issue will further reduce proceeds. We can use the constant-growth valuation model expression for the cost of...

Features Of Preferred Stock

The issuer of preferred stock determines, with the help of an underwriter, the features of the preferred stock. These features affect the cost of the stock, the issuer's flexibility in changing its capital structure, and the role of preferred shareholders in the governance of the firm, among other things. We'll first take a look at the different preferred stock features that are typically used. Then we'll see how these features can be packaged together to provide a source of financing that meets the issuer's needs and the investors' preferences.

The Link Between Stock Price And Earnings Per Share

Investors often use the terms growth stocks and income stocks. They buy growth stocks primarily for the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year's dividends. On the other hand, they buy income stocks primarily for the cash dividends. Let us see whether these distinctions make sense. Imagine first the case of a company that does not grow at all. It does not plow back any earnings and simply produces a constant stream of dividends. Its stock would resemble the perpetual bond described in the last chapter. Remember that the return on a perpetuity is equal to the yearly cash flow divided by the present value. The expected return on our share would thus be equal to the yearly dividend divided by the share price (i.e., the dividend yield). Since all the earnings are paid out as dividends, the expected return is also equal to the earnings per share divided by the share price (i.e., the earnings-price ratio). For example,...

Do Stock Prices Reflect Long Term or Short Term Events

Managers often complain that the stock market is shortsighted, and that it cares only about next quarter's performance. Let's use the constant growth model to test this assertion. MicroDrive's most recent dividend was 1.15, and it is expected to grow at a rate of 8 percent per year. Since we know the growth rate, we can forecast the dividends for each of the next five years and then find their present values Recall that MicroDrive's stock price is 23.00. Therefore, only 5.00, or 22 percent, of the 23.00 stock price is attributable to short-term cash flows. This means that MicroDrive's managers will have a bigger effect on the stock price if they work to increase long-term cash flows rather than focus on short-term flows. This situation holds for most companies. Indeed, a number of professors and consulting firms have used actual company data to show that more than 80 percent of a typical company's stock price is due to cash flows expected more than five years in the future. This...

Corporate Use Of Preferred Stock

Preferred stock is generally considered the Wall Street wallflower. Seldom issued, preferred stock is usually associated with financially troubled firms. Recently, several major U.S. companies issued preferred stock as a source of additional equity capital. Examples of preferred stock issues in the 1990s include Ford Motor Company, RJR Nabisco Holdings, Kmart, and General Motors. These issues did not do much to change preferred stock's image, since these companies issued preferred stock at times when they were cash-poor or on the brink of a debt downgrade. Why would a company issue preferred stock One advantage of using preferred stock as a source of capital is that, in general, the firm must pay only a fixed amount in dividends, leaving the upside potential in earnings to be reaped by common shareholders. Another advantage is that the voting control of common shareholders is not diluted, as it would be if common shares were issued. Still another advantage is the cost of preferred...

Modeling Stock Market Prices

In his doctoral thesis 2 written in 1900, Bachelier laid the groundwork for the study of stock market pricing. A discussion of different approaches is given in 6 . Much of the material in this and the next section follows arguments developed in 23 . We now discuss the pricing of options. Because the price of an option depends, in large part, on the price of the underlying stock, we first discuss the pricing of stocks, which in turn depends on how stock market prices are modeled. The binomial model of stock prices is a discrete model. We assume that a stock trades during a fixed time interval 0,T , and we divide the interval into n equally spaced subintervals The model is the following If the stock price is S(tj) at time tj, then we assume that it may increase to price SU (tj+i) with probability P (tj) at time tj+i or decrease to price SD(tj+i) with probability 1-P(tj).ii We also assume that the price changes S(ti) - S(t0), S(t2) - S(ti), , S(tn) - S(tn-i) are independent. Then at each...

Has Target Capital Structure Of 60 Common Stock 30 Debt And 10 Preferred Stock. The Company Wishes To Issue New 30

The effect of tax rate on WACC Equity Lighting Corp. wishes to explore the effect on its cost of capital of the rate at which the company pays taxes. The firm wishes to maintain a capital structure of 30 debt, 10 preferred stock, and 60 common stock. The cost of financing with retained earnings is 14 , the cost of preferred stock financing is 9 , and the before-tax cost of debt financing is 11 . Calculate the weighted average cost of capital (WACC) given the tax rate assumptions in parts a to c. Preferred stock 50,000 1Z.0 Common stock equity 650,000 16.0 Preferred stock 40,000 60,000 13.0 Common stock equity 1,060,000 3,000,000 17.0 Preferred stock 15 Common stock equity 55 The cost of debt is estimated to be 7.2 the cost of preferred stock is estimated to be 13.5 the cost of retained earnings is estimated to be 16.0 o and the cost of new common stock is estimated to be 18.0 . All of these are after-tax rates. The company's debt represents 25 , the preferred stock represents 10 , and...

6 Percent Preferred Stock For 95.12

Calculate the arithmetic average returns for large-company stocks and T-bills over this time period. b. Calculate the standard deviation of the returns for large-company stocks and T-bills over this time period. c. Calculate the observed risk premium in each year for the large-company stocks versus the T-bi 11 > . What was the arithmetic average risk premium over this period1.' What was the standard deviation of the risk premium over this period 14. Calculating Returns. You bought a share of 6 percent preferred stock for 95.12 last year. The market price for your stock is now 93.80. What is your total return for last year 18. Return Distributions. Refer back to Figure 10.10. What range of returns would you expect to see 68 percent of the time for large-company stocks What about

Cost of Common Stock rs

Few mature firms issue new shares of common stock.4 In fact, less than 2 percent of all new corporate funds come from the external equity market. There are three reasons for this 2. Investors perceive issuing equity as a negative signal with respect to the true value of the company's stock. Investors believe that managers have superior knowledge about companies' future prospects, and that managers are most likely to issue new stock when they think the current stock price is higher than the true value. Therefore, if a mature company announces plans to issue additional shares, this typically causes its stock price to decline. Whereas debt and preferred stock are contractual obligations that have easily determined costs, it is more difficult to estimate rs. However, we can employ the principles described in Chapters 3 and 5 to produce reasonably good cost of equity estimates. Three methods typically are used (1) the Capital Asset Pricing Model (CAPM), (2) the discounted cash flow (DCF)...

Investment and the Stock Market

We noted above that in the largest developed economies, corporations finance most of their investment expenditure from internal resources ultimately this is shareholders' capital. The stock market valuation of companies' existing capital reflects the return that shareholders might earn on funds. So we should expect to see a link between levels of investment companies undertake and the stock market. In fact, the link was elegantly and formally set out many years ago by James Tobin, who developed the so-called q theory of investment. Tobin noted that if the value of a company on the stock market was substantially more than the replacement cost of the assets that the firm employs (most of which we will assume are some form of capital equipment), then in principle that company has a major incentive to increase investment. When we think about the replacement value of capital here, we mean the current cost of buying the sorts of machines that the company uses. If the ratio between the value...

The q theory of investment implies that we should expect to see a strong link between movements in the stock market

What about the cost of capital If a firm is generating just enough profits to satisfy its shareholders, we would expect that the ratio of profits to stock market value is equal to shareholders' required rate of return. So a measure of the cost of capital is profits stock market value of firm profit replacement cost of capital profit stock market value of firm stock market value of firm replacement cost of capital q The q theory of investment implies that there should be a positive link between stock market valuations (relative to the purchase cost of plant, machines, buildings, and so forth) and the level of investment. But empirical evidence suggests that there is not such a clear link. Figure 13.8 plots changes in the level of investment expenditure in the United States charted against the change in stock prices. While the two move roughly in line, the correlation between them is low. Similar pictures could be drawn for all the major economies. What are we to make of the relatively...

The Upper Chart Compares Gold Stocks To Money Center Stocks As 1989 Ended Some Money Fleeing Financial Stocks Went To

As long as the CRB bond ratio was falling earlier in the year, odds favored the interest-sensitive stocks. The CRB bond ratio bottomed in August of 1989 and continued to stabilize through the fourth quarter. In December, the ratio broke out to the upside and confirmed that a trend change had, in fact, taken place. The pendulum, which had favored bond prices for a year, now showed commodity prices in the ascendancy. That crucial shift explains the dramatic move away from interest-sensitive stocks toward commodity stocks. And, in doing so, this shift also warned of the uptick in interest rates which began to push stock prices lower.

Types of Common Stock

Although most firms have only one type of common stock, in some instances classified stock is used to meet the special needs of the company. Generally, when special classifications are used, one type is designated Class A, another Class B, and so on. Small, new companies seeking funds from outside sources frequently use different types of common stock. For example, when Genetic Concepts went public recently, its Class A stock was sold to the public and paid a dividend, but this stock had no voting rights for five years. Its Class B stock, which was retained by the organizers of the company, had full voting rights for five years, but the legal terms stated that dividends could not be paid on the Class B stock until the company had established its earning power by building up retained earnings to a designated level. The use of classified stock thus enabled the public to take a position in a conservatively financed growth company without sacrificing income, while the founders retained...

Economic Growth And Stock Prices

It surprises the general public and even the financial press when a strong economic report sends the stock market lower. But stronger-than-ex-pected economic growth has two important implications for the stock market, and each tugs in the opposite direction. A strong economy increases future corporate earnings, which is bullish for stocks. But it also raises interest rates, which raises the discount rate at which these future profits are discounted. Similarly, a weak economic report may lower ex pected earnings but if interest rates decline, stock prices could possibly move up because of the decline in the rate at which these profits are discounted. It is a struggle, in asset pricing terms, between the numerator, which contains future cash flows, and the denominator, which discounts those cash flows. Which effect is stronger the change in the interest rate or the change in corporate profits depends often on where the economy is in the business cycle. Recent analysis shows that in a...

Growth Stocks and Income Stocks

We often hear investors speak of growth stocks and income stocks. They seem to buy growth stocks primarily in the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year's dividends. On the other hand, they Suppose that another stock market analyst predicts that United Bird Seed will not settle down to a constant 5 percent growth rate in dividends until after Year 4, and that dividends in Year 4 will be 1.73 per share. What is the fair price for the stock according to this analyst

Ubsidiary Preferred Stock

The existence of preferred stock in the capital structure of a subsidiary complicates the calculation of a parent's claim on subsidiary retained earnings, both at the time of acquisition and in the preparation of subsequent consolidated statements. In previous examples, the subsidiary had only common stock outstanding, so that all retained earnings were associated with common stock, and the parent had a claim on subsidiary retained earnings in proportion to its ownership interest. When a subsidiary has preferred stock outstanding, however, the preferred stock also may have a claim on retained earnings. This claim may be caused by a liquidation value in excess of par value and or by participation and cumulative dividend rights. When these conditions exist, the retained earnings must be divided between the preferred and common stockholder interests. Once retained earnings are allocated between the common and preferred stockholders, the intercompany investments can be eliminated. The...

Model of the Behavior of Stock Prices

In this chapter we derive a continuous-variable, continuous-time stochastic process for stock prices. An understanding of this process is the first step to understanding the pricing of options and other more complicated derivative securities. It should be pointed out that in practice we do not observe stock prices following continuous-variable, continuous-time processes. Stock prices are restricted to discrete values (usually multiples of and changes can be observed only when the exchange is open. Nevertheless, the continuous-variable, continuous-time process proves to be a useful model for most purposes.

How can one calculate the present value of a stock given forecasts of future dividends and future stock price

Unlike the fixed interest payments that the firm promises to bondholders, the dividends that are paid to stockholders depend on the fortunes of the firm. That's why a company's common stock is riskier than its debt. The return that investors expect on any one stock is also the return that they demand on all stocks subject to the same degree of risk. The present value of a stock equals the present value of the forecast future dividends and future stock price, using that expected return as the discount rate.

Were the Japanese Stock Prices Too High

Japan Stock Bubble

This is the question investors have been asking about the Japanese stock market. As can be seen from the chart below, an investment of one yen, placed in a diversified portfolio of Japanese stocks on the last day of 1969, would have grown to about 18 yen by 1988. By contrast, the tables in Chapter 9 can be used to show that a 1 investment in American stocks would have only risen to under 7 over the same time period. During this time period, the average price-earnings ratio for Japanese stocks was much higher than that for American stocks. For example, the Japanese P E ratio was 54.3 in However, as can be seen from the chart below, Japanese stocks took quite a fall after 1988. By the end of 1993, the 18 1 ratio had dropped to 9 1. It has stayed at about 9 1 over the ensuing years. By contrast, the U.S. ratio had risen from 7 1 to over 22. Not surprisingly, the P E ratios had moved closer together. By the middle of 1997, the Japanese P E ratio was approximately 44, while the American P...

Recognizably Overpriced Stocks Can Exist

This simple observation that prices are set by the optimistic investors and that these are sometimes wrong is useful. It can explain why there do appear to be overvalued stocks that are widely agreed to be overvalued. 8 Ofek and Richardson, Dotcom Mania The Rise and Fall of Internet Stock Prices. 9 The only weak point in the argument is that to the extent these investors did not have the same optimism about payoffs that existing investors had, their beliefs would now get incorporated into stock prices. The problem is that the selling by most of these investors need not be caused by less optimism about returns (although this was probably true of some), or even about risk in some absolute sense, but merely by a desire for diversification. The incremental effect of a share of the risk of a portfolio is greater when there is already much of the stock in the portfolio than when there is little. The result (using Markowitz optimization or something similar) is that the premium (often called...

Us Stock Market Profits And Losses

(1) Total U.S. stock market profits and losses include stock positions and index futures. FOREIGN STOCK MARKET PRICES Control Period 12 9 1985 to 7 20 1986 FOREIGN STOCK MARKET PRICES Control Period 12 9 1985 to 7 20 1986 European Stock Markets Index (in U.S. dollars) Japanese Stock Market Index (in U.S. dollars)

Taxes and Preferred Stock

Chapter 3 noted that preferred stock is similar to a bond because it has a fixed payout. In contrast to bonds, however, preferred shareholders cannot force the firm into bankruptcy if the firm fails to meet its dividend obligation. Although the claims of a preferred stockholder are always junior to the claims of the firm's debt holders in the event of bankruptcy, such claims are senior to the claims of the firm's common stockholders. The common stockholders cannot receive a dividend until the preferred dividends (including all past dividends) are paid. In addition, preferred shareholders, unlike debt holders, often have voting rights. Perhaps one of the most important differences between preferred stock and bonds is that the dividends of preferred stock are not tax deductible, while the coupon payments of a bond are. This has led some analysts to conclude that subordinated bonds provide cheaper financing than preferred stock. However, a feature of the U.S. tax code provides an...

Example 147 The Effect of Taxes on the Decision to Invest in Preferred Stock

Connolly Partners, Inc., seeks to invest excess funds in either the straight bonds or preferred stock of Pacific Gas and Electric (PG& E). In March 1990, a 10.125 percent PG& E bond had a yield to maturity of 9.79 percent. The 10.18 percent preferred stock, although riskier, was yielding a 9.4 percent dividend. If Connolly's marginal tax rate is 34 percent, which alternative will it prefer Answer Connolly Partners will receive an after-tax yield of 6.46 percent (.66 x 9.79 ) if it invests in the bonds and an after-tax yield of 8.44 percent (9.4 x .30 x .66) + (9.4 x .70) in the preferred stock. In this case, the preferential tax treatment gives the firm an incentive to invest in preferred stock even though the preferred stock is riskier and has a lower yield. A firm that is certain to have positive taxable earnings will have a lower after-tax cost of capital if it issues a bond instead of preferred stock. However, if the firm is likely to have negative taxable earnings for...

Convertible Preferred Stock

The Bedford Bicycle Company has 3,000 shares of 10 par preferred stock outstanding. The stock originally had been issued for 16 per share. It is convertible into shares of common stock at the rate of five shares of 1 par common for every share of preferred. No cash would be paid by the converting shareholders. This convertible preferred stock pays a dividend of 1 per share per year. A. Assume there are 40,000 shares of common stock outstanding, originally issued at 30 per share, but having a current market value of 32 per share. The retained earnings account balance is 3,200,000. Prepare the stockholders' equity section of the balance sheet before conversion of any preferred stock. B. Now, assume that all of the preferred stock is converted to common stock. Prepare the stockholders' equity section of the balance sheet. Compare and explain the totals in stockholders' equity before and after the conversion of the preferred stock. C. Explain how the conversion of preferred stock into...

Stock Prices Are Lognormally Distributed

Another implication of our assumption that stock prices follow a geometric Brownian motion is that stock prices are lognormally distributed, that is, the natural logarithm of stock prices are normally distributed. If S0 is the stock price now and ST the price at time T we can write Note that the mean of the distribution for the logarithm of the stock price ratio is not but - 72 2, which is important. Because the stock price itself is lognormally distributed, we cannot calculate the expected value or the variance of the stock price at time T directly from the above distribution. For example, the expected value of the stock price is given by From this we can get an intuitive understanding of how stock prices evolve under the geometric Brownian motion assumption. The expected value of the stock price grows at the rate of , continuously compounded, and an uncertainty component is superimposed on it to generate the fluctuating stock price we observe. Unlike a normal distribution, a...

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