Class 2

Valuation of Cash Flow Streams

Common Stock Stockholders are owners of the firm. Stockholders are residual claimants. Stockholders have the right to:

vote at company meetings dividends and other distributions sell their shares

Stockholders benefit in two ways: dividends capital gains

Issuing and Trading Stock

Stock is issued by public corporations to finance investments.

Stock is initially issued in the primary market (IPOs and secondary offerings).

Stock is traded in the secondary market on organized exchanges.

World Stock Markets

New York Tokyo London Frankfurt Paris Mexico Canada Brussels

Hong Kong Singapore Johannesburg Sydney Stockholm Milan Amsterdam Switzerland

Major U.S. Stock Exchanges

New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Over-The-Counter (OTC)

National Association of Securities Dealers (NASDAQ)

Major U.S. Stock Indices

Dow Jones Industrial Average Standard & Poors 500 NYSE Composite NASDAQ Composite Value Line Russell 2000 Wilshire 5000

Transactions Involving Stocks

Buy Savings motive Expect stock to appreciate in value Long position

Sell Liquidity needs Expect stock to decline in value

Transactions Involving Stock

Short Sell Sell stock without first owning it. Borrow stock from your broker with the

promise to repay it at some later date. Sell the borrowed stock. Repurchase it at a later date to repay your

broker. Responsible for all dividends and other

distributions while short the stock.

Stock Valuation

The price an investor is willing to pay for a share of stock depends upon: Magnitude and timing of expected future

dividends. Risk of the stock.

The stock’s discount rate, re, is the rate of return investors can expect to earn on securities with similar risk.

Stock Valuation:Dividend Discount Model

Pd

rt

e

tt

n

01 1

b g

Pd

r

d

r

d

re e

n

e

n01

12

21 1 1

b g b g b g...

The value of a stock is the present value of all future dividends:

Simplifying the Dividend Discount Model

Constant Dividends

Constant Growth

Pd

re0

Pd

r ge0

1

Constant Dividends:RJR Nabisco Preferred

Stock RJR Nabisco has a preferred stock

outstanding with an annual dividend of $2.50 per share. If securities with similar risk are expected to return 9.6%, what is the price of the preferred stock?

P0

2 50

0 09604

.

.$26.

Constant Growth:Duke Power Common

Stock Duke Power currently pays a dividend of

$2.04 per share. With demand for electric power growing at 4% per year, and inflation averaging 3% per year, Duke Power expects its profits and dividends to grow at about 7% per year. If stockholders require a 12% rate of return, what is the market price of Duke Power’s common stock?

Duke Power (cont.)

Duke Power’s common stock price:

P0

2 04 107

012 0 0766

. ( . )

. .$43.

Pd

r ge0

1

Valuing a Business Consider a company with cash flows from operations

of $1 million for the most recent year. The company’s cash flows are expected to grow at a

rate of 10% for the next 5 years and at a constant rate of 5% thereafter.

To generate this increase in cash flows, the company is required to reinvest 50% of its cash flows for the first 5 years and 25% of its cash flows thereafter.

Given the risk of the business, the required rate of return is 15%.

What is the value of the business?

Valuing a Business (cont.)

Year 1 Year 2 Year 3 Year 4 Year 5OperatingCash Flows

1.10 1.21 1.33 1.46 1.61

New CapitalInvestment

-0.55 -0.61 -0.67 -0.73 -0.81

Net CashFlow (Div)

0.55 0.60 0.66 0.73 0.80

PresentValue

0.48 0.45 0.43 0.42 0.40

Valuing a Business

Value of dividends over the first 5 years is $2.18.

Value of business at the end of the 5th year:

Pd

r ge5

6 161 1 0 25 105

015 0 0568

. ( . ) .

. .$12.

Valuing a Business (cont.)

Value of the Business:

Pd

r

P

rt

e

tt e

01

55

51 1

b g b g

P0 52 1812 68

11548 .

.

.$8.b g

Estimating Relevant Cash Flows

The relevant cash flows for evaluating a new investment project are the incremental cash flows contributed by the project.

Incremental = Firm’s CFs - Firm’s CFs

Cash Flows with Project without Project

Estimating Relevant Cash Flows: Basic Principles

Discount Cash Flows, Not Accounting Profits.» For capital budgeting purposes, the point of

recognition is when the money is actually received or spent.

» Don’t forget the effect of taxes.

Estimating Relevant Cash Flows: Basic Principles

Separate Investment and Financing Decisions» Ignore all financing costs, even if the project is

partially financed with debt.» Treat the project as if it were all-equity

financed.» Financing side effects will be considered later.

Estimating Relevant Cash Flows: Basic Principles

Only Incremental Cash Flows are Relevant.» Include all incidental effects, including

project interactions.» Don’t forget to include investment in

working capital. » Forget about sunk costs.» Include all opportunity costs (e.g., land

used to construct a new plant).» Beware of allocated overhead expenses.

Depreciation

Depreciation is a non-cash expense that only affects cash flows through its tax effect.

Assets are depreciated down to their estimated salvage values.

Any removal costs associated with old equipment are expensed immediately.

Depreciation

Sales tax, delivery costs, and installation are regarded as part of the cost of the new asset for depreciation purposes.

Removal costs of the old asset are not regarded as part of the cost of the new asset and are expensed immediately.

If an asset is later sold for an amount above (below) its book value, the excess is taxable (deductible).

Example: Estimating Cash Flows

A new machine costs $60,000 plus installation costs of $2,000. It generates revenues of $155,000 and expenses of $100,000 annually. It will be depreciated to its estimated salvage value over of $6,000 over its seven year life. What are the relevant cash flows?

Step 1: Compute Tax Cash Flow

Year 0 1 ... 7Revenues 155,000 ... 155,000Expenses -100,000 ... -100,000Depreciation -8,000 ... -8,000Taxable Income 47,000 ... 47,000Tax 15,980 ... 15,980

Step 2: Compute Cash Flows

Year 0 1 ... 6 7Revenues 155,000 ... 155,000 155,000Expenses -100,000 ... -100,000 -100,000Tax -15,980 ... -15,980 -15,980Cost of Machine -62,000Salvage 6,000Net Cash Flow -62,000 39,020 ... 39,020 45,020