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Common Stock: Characteristics, Valuation, and Issuance

©2006 Thomson/South-Western

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Introduction

This chapter describes the characteristics of common stock.

It discusses the process for selling securities and the role of the investment banker.

The chapter also develops valuation models for common stock.

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Common Stock

Common stock (C/S) is the permanent long-term financing of a firm.

Represents the true residual ownership of a firm

Stockholders elect the board of directors.

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Balance Sheet Accounts for C/S Par value of C/S

Contributed capital in excess of par Additional paid in capital Capital surplus

Retained earnings (R/E)

Book value per share

Common equity

# shares outstanding

=

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Rights of Common Stockholders

Dividend rights

Asset rights

Preemptive rights

Voting rights

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Voting for the Board of Directors Majority voting requires more than 50

percent of the votes to elect a director.

Cumulative voting Shareholders may concentrate votes on a few

candidates.

Proxy signing over your voting rights to someone else

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Features of C/S

C/S classes Voting and nonvoting Specific ownership

Stock dividends Transfer from R/E

account to the C/S and additional paid-in capital accounts

Stock repurchases Disposition of excess

cash Financial restructuring Future corporate needs Reduction of takeover

risk Stock splits Reverse stock splits

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C/S Advantages and Disadvantages Advantages

Flexible Reduced financial leverage Lower cost of capital

Disadvantages Diluted EPS Expensive

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Investment Banking

Long-range financial planning

Timing of security issues

Purchase of securities

Marketing of securities

Arrangement of private loans and leases

Negotiation of mergers

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How Are Securities Sold?

Public cash offering Selling securities through investment bankers to the

public IPO’s Web site: http://www.ipo.com/

Private or direct placement Placing a security issue with one or more large

investors Rights offering

Selling C/S to existing stockholders Standby underwriting

Investment banker purchases shares not sold to rights holder.

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Direct Issue Costs

Investment bankers who agree to underwrite a security issuance assume a certain amount of risk, and receive an underwriting spread as compensation.

Underwriting Spread = Selling price to public – Proceeds to company

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Other Issuance Costs

Management time

Underpricing new equity

Stock price declines

Incentives

“Green shoe” option

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Registration Requirements SEC act of 1933 & SEC exchange act of 1934 Any interstate security issue over $1.5

million and having a maturity greater than 270 days is required to register issue with the SEC.

Provide all buyers of the new security with a final copy of the prospectus

Shelf registration Check NYSE regulations http://www.nyse.com/about/about.html

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Global Equity Markets

Multinational firms can take advantage of institutional differences from one country to another.

Stock markets in United States, Japan, London, and Paris

Nearly 24-hour per day trading of C/S Provide investors with opportunities to

buy and sell shares any time they wish Global name and product recognition

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Valuation of C/S

Capitalized value of the stock’s expected stream of cash flow during holding period

Uncertain

Dividends Not constant

Expected to grow over time

Capital gain or loss

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Dividend Valuation Models Zero growth

g = 0

Constant growth dividend ke > g

Dt = D0 (1 + g)t

Above-normal growth Multiple growth rates

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Zero Growth

e

0kD

P

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Example of Zero Growth Valuation

P0 = $1.500.12

=$12.50

A share of stock will pay $1.50 dividend next year. If the required rate of return is 12%, the value of the share is:

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Constant Growth

gk

DP

e

10

gP

Dk

0

1e

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Example of Constant Growth Valuation

P0 = $1.760.12- 0.065

=$32.00

A share of stock will pay $1.76 dividend next year. The dividend will grow at a 6.5% annual rate. If the required rate of return is 12%, the value of the share is:

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Above-Normal Growth

1. Find the PV of the dividends during the above-normal growth period (if two or more above-normal growth periods continue with the PV of the second)

2a.Find the value of the C/S at the end of the above-normal growth period

2b.Discount the answer in 2a to the present time

3. Sum steps 1 and 2b to find p0

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Sources of Analyst Growth Rate Forecasts Value Line Investment Survey

http://www.valueline.com/

Institutional Brokers Estimate System http://www.ibes.com/

Zacks Earnings Estimates http://www.zacks.com/

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Valuing Small Firms

Nature of business

History of business

Economic outlook

Dividend paying

capacity

Industry

Earnings capacity

Book value

Financial condition

Majority or minority

interest

Voting or nonvoting

Valuation Web site: http://www.bearval.com/