Financial Management Chapter 8 K

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Chapter 8
Stocks and Their Valuation


After reading this chapter, students should be able to:

• Identify some of the more important rights that come with stock ownership and define the following terms: proxy, proxy fight, takeover, and preemptive right.

• Briefly explain why classified stock might be used by a corporation and what founders’ shares are.

• Differentiate between closely held and publicly owned corporations and list the three distinct types of stock market transactions.

• Determine the value of a share of common stock when: (1) dividends are expected to grow at some constant rate, (2) dividends are expected to remain constant, and (3) dividends are expected to grow at some super-normal, or nonconstant, growth rate.

• Calculate the expected rate of return on a constant growth stock.

• Apply the total company (corporate value) model to value a firm in situations when the firm does not pay dividends or is privately held.

• Explain why a stock’s intrinsic value might differ between the total company model and the dividend growth model.

• Explain the following terms: equilibrium, marginal investor, and Efficient Markets Hypothesis (EMH); distinguish among the three levels of market efficiency; briefly explain the implications of the EMH on financial decisions; and discuss the results of empirical studies on market efficiency and the implication of behavioral finance on those results.

• Read and understand the stock market page given in the daily newspaper.

• Explain the reasons for investing in international stocks and identify the “bets” an investor is making when he does invest overseas.

• Define preferred stock, determine the value of a share of preferred stock, or given its value, calculate its expected return.


This chapter provides important and useful information on common and preferred stocks. Moreover, the valuation of stocks reinforces the concepts covered in both Chapters 6 and 7, so Chapter 8 extends and reinforces those chapters. We begin our lecture with a discussion of the characteristics of common stocks, after which we discuss how stocks are valued in the market and how stock prices are reported in the press. We conclude the lecture with a discussion of preferred stocks. The details of what we cover, and the way we cover it, can be seen by scanning Blueprints Chapter 8. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.

DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods)

8-1True. The value of a share of stock is the PV of its expected future dividends. If the two investors expect the same future dividend stream, and they agree on the stock’s riskiness, then they should reach similar conclusions as to the stock’s value.

8-2A perpetual bond is similar to a no-growth stock and to a share of preferred stock in the following ways:

1.All three derive their values from a series of cash inflows--coupon payments from the perpetual bond, and dividends from both types of stock.

2.All three are assumed to have indefinite lives with no maturity value (M) for the perpetual bond and no capital gains yield for the stocks.

8-3Yes. If a company decides to increase its payout ratio, then the dividend yield component will rise, but the expected long-term capital gains yield will decline.

8-4No. The correct equation has D1 in the numerator and a minus sign in the denominator.

8-5a.The average investor in a listed firm is not really interested in maintaining his proportionate share of ownership and control. If he wanted to increase his ownership, he could simply buy more stock on the open market. Consequently, most investors are not concerned with whether new shares are sold...
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