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Source: http://www.doksinet Chapter 7 – Equity Markets and Stock Valuation The price of any financial instrument is the present value of the future cash flows. Preferred Stock There is a 6 percent preferred share outstanding. If investors have a required return of 7 percent on this stock, what is the price? P0 = D R P0 = 6 = $85.71 .07 Common stock Assumption: The dividends grow at a constant rate forever. The following equation goes by many names. Here are a few: Gordon Growth Model Discounted Dividend Model Dividend Model P0 = D1 D (1 + g) = 0 R -g R -g Suppose a stock will pay a dividend of $2.50 next year and the dividends will grow at 6 percent forever. If the required return is 13 percent, what is the price per share today? P0 = $2.50 = $35.71 .13 - 06 Fin 311 Chapter 7 Lecture Notes Page 1 Source: http://www.doksinet Suppose a stock just paid a dividend of $1.80 and the dividends will grow at 6 percent indefinitely. If the required return is 11 percent, what is

the current stock price? P0 = D1 $1.80(1 + 06) = $38.16 = R -g .11 - 06 What is the stock price in 8 years? P8 = D9 $1.80(1 + 06) 9 = = $60.82 R -g .11 - 06 P 8 = $38.16(1 + 06)8 = $6082 What is the stock price in 15 years? P15 = D16 $1.80(1 + 06)16 = = $91.45 R -g .11 - 06 P 15 = $38.16(1 + 06)15 = $9145 Page 2 Fin 311 Chapter 7 Lecture Notes Source: http://www.doksinet Growing Perpetuities You want to buy a song catalog. The royalties next year will be $1 million, and are expected to decrease by 8 percent per year indefinitely. If you want a 13 percent return, what is the most you should pay for the catalog? P0 = $1,000,000 $1,000,000 = = $4,761,904.76 .13 - (- 008) 0.21 Where does g come from? g = ROE × b Required Return We can solve the Gordon Growth Model for R, the required return. R= D (1 + g ) D1 +g= 0 +g p0 P0 Fin 311 Chapter 7 Lecture Notes Page 3 Source: http://www.doksinet We are analyzing a stock with a current price of $25 per share. The current

dividend (D 0 ) is $1 per share and is expected to grow at 4.5 percent per year indefinitely What is the required return for this stock? R= D0 (1 + g ) 1(1.045) +g= + 0.045 = 00868 868% P0 25 We will not cover the non-constant growth section. Read Sections 7.2 and 73 Page 4 Fin 311 Chapter 7 Lecture Notes