Short Question Answer
1. What are the characteristic features of preference share?
Preferred stock is a hybrid security issued by companies. It is called hybrid security because it has some features common to debt and others similar to common stock. The rate of dividend to be paid on preferred stock is fixed and it generally has fixed maturity after which preferred stockholders are repaid. These features are similar to debt. Though preferred stock dividend is fixed, non-payment of preferred stock dividend does not lead the company into bankruptcy as in the case of common stock dividend payment. Some important features of preferred stock are as follows:
- Par value: Preferred stock has a stated par value. Par value shows the amount due to the preferred stockholders in the event of liquidation or maturity. The preferred stock dividend is paid as a percentage on par value.
- Fixed dividend: Preferred stockholders receive fixed dividends. However, a company can postpone the preferred stock dividend payment if it does not have sufficient profit.
- Maturity: Preferred stocks have specified maturity dates. On the expiry of maturity date preferred stockholders are repaid.
- Cumulative feature: Some preferred stocks are issued with cumulative features. It allows the unpaid dividend in any year to be cumulative and paid in the later year.
- Participating feature: Participating feature allows the preferred stockholders to participate with common stock in the residual earnings of the firm.
- Voting rights: Preferred stockholders do not have the voting right. However, they are given special voting rights if the company does not pay preferred stock dividends for a specified period.
- Claims on asset and income: Preferred stock has prior claim on assets and income than common stock but later claim than debt. h. Call feature: Call feature allows the issuer the right to call the preferred stock for redemption at a specified price before maturity date. However, the call price to be paid upon call is usually higher than par value.
- Conversion feature: A convertible preferred stock can be converted into a specified number of common stocks at the holders’ desire within a specified period of time.
- Adjustable-Rate and Payment-in-kind Preferred Stock: Adjustable rate preferred stocks have a dividend rate that is tied to the interest rates on specific government securities. Payment-in-kind preferred stock pays dividend in the form of additional shares of preferred stock or in kind instead of cash dividend.
2. Discuss the features of common stock.
Common stock is securities issued by corporations to raise ownership capital. Capital raised by issuing shares of common stock is used to finance a major portion of the firm’s fixed assets. Common stock certificate represents the evidence of ownership rights of the holders in the corporation. Some of the basic features of common stock are as follows:
- Par value: Common stock has a stated amount of face value per share, which is called par value. The par value is generally set at Rs 100 per share of common stock.
- Limited liability: Common stockholders of a company are its real owners and their liability is limited to the amount of their investment.
- Residual claim: Common stockholders have residual claims on income and assets. Common stock dividend is paid after payment of interest to the creditors, tax to the government and preferred dividend to the preferred stockholders. Similarly, in the event of liquidation, common stockholders have a residual claim on the assets of the company after the claim of all creditors and preferred stockholders are settled in full.
- No maturity: Common stock does not have a maturity date. Hence, the company which needs funds for an indefinite period issues shares of common stock. Shareholders. however, can sell their stocks in the secondary market
- Voting right: Each share of common stock entitles its holder to cast one vote in the annual general meeting of shareholders Common stockholders can attend the annual general meeting and cast vote in person or by means of a proxy.
- Preemptive right: Pre-emptive night gives the existing common stockholders the first right to subscribe into new issues of shares. This right allows the existing shareholders to maintain their proportionate ownership interest and control in the company.
3. Stock valuation
Stock valuation is the process of determining intrinsic or fair value of common stock. Intrinsic value of common stock is the sum of the present values of all future cash flows associated with common stock investment, discounted at shareholders’ required rate of return. Valuation of common stock is difficult than the valuation of bond due to several reasons. One reason is that expected cash flows from common stock are not known in advance as opposed to the cash flows from bond and preferred stock investment. Another reason is that common stock dividends are normally expected to grow and the growth rate may vary over periods. Furthermore, the life of the investment in common stock is theoretically indefinite, since common stock has no maturity. Because of these complexities associated with common stock valuation, a number of approaches can be used to determine the fair value of common stock. One of the most popular model to determine common stock value is the dividend discount model. In this model, future streams of expected dividends are used as the basic input for common stock valuation. Investors, who purchases common stock receives dividend during the holding period and also realizes proceeds from sale of stock at the end of the period. Thus, value of common stock in this case is the sum of the present value of future dividend payments plus present value of price of the stock at the end of the period. If the investors expect to hold the common stock forever, they expect infinite stream of dividends from common stock. In this case, value of common stock is the sum of the present values of infinite stream of dividend payments. The basic dividend discount model is worked out as follows:
Where,
Po = intrinsic value per share of common stock
D₁ = dividend per share expected at the end of year t
Ks = investors’ required rate of return
Thus, the dividend discount model defines the intrinsic value of a share of common stock as the present value of future dividends.
Numerical Problems
1. Everest Biscuit Company’s current stock price is Rs.36, and its last dividend was Rs.2.40. In view of the company’s strong financial position and its consequent low risk, its required rate of return is only 12 percent. If dividends are expected to grow at a constant rate in the future, and if the required rate of return on stock is expected to remain at 12 percent, what is the company’s expected stock price 5 years from now?
SOLUTION
We have.
Current stock price (Po) = Rs 36
Current dividend per share (Do) = Rs 2.40
Required rate of return (ks) = 12%
If dividend is expected to grow at a constant rate, the growth rate in dividends is worked out as follows:
2. Gorakhkali Textiles Limited recently paid a dividend, DO, of Rs. 1.25. The company expects to have supernormal growth of 20 percent for 2 years before the dividend is expected to grow at a constant rate of 5 percent. The firm’s weighted average cost of capital is 10 percent.
(a) What year is the terminal, or horizon, date?
(b) What is the firm’s horizon, or terminal, value per share?
SOLUTION
We have,
Recent dividend per share (Do) = Rs 1.25
Supernormal growth rate for 2 years (gs) = 20%
Constant growth rate (gn): 5%
Weighted average cost of capital (WACC) = 10%
(a) The terminal, or horizon date, is the date when the supernormal growth period ends. Since the dividend grows at 20 percent supernormal rate for 2 years, the terminal or horizon date is 2 years.
(b) Horizon, or terminal, value per share is the value at the end of the supernormal period (P₂). It is calculated as follows:
P2= D3 / (ks-g) = Rs 1.8 (1.05) / 0.10-0.05 = Rs 37.8
Where,
D₂ = Do (1 + g)² = Rs 1.25 x (1.20)² = Rs 1.80
3. Eastern Mining Company’s ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its cost is rising. As a result, the company’s earnings and dividends are at the constant rate of 6 percent per year. If Do = Rs. 8; and is = 15 percent,
a. What is the value of a company’s stock?
b. Assuming all the variables remain same except ks =12% by what percentage the value of the common stock changes?
c. If a stock is not in equilibrium, explain how financial markets adjust to bring it into equilibrium.
c. If stock is not in equilibrium but over or underpriced then financial markets adjust to bring it into equilibrium. If the stock is overpriced, selling pressure increases in the market. This leads to an increase in supply of the stock, which ultimately causes the stock price to decline to adjust towards equilibrium. In the opposite case, when stock is underpriced, buying pressure increases in the market. This will cause the demand for stock to increase and the price of stock also to increase to adjust towards equilibrium.
Long Question Answer
1. Nabil bank has just paid a cash dividend of Rs 40 per share. Investors require a 25 percent return from such type of investment. If the dividend is expected to grow at a constant rate of 12 percent per year, what is the current value of stock? What will be the worth of the stock in 3 years?
2. Delta Company is expected to pay a Rs 25 per share dividend at the end of the year. The dividend is expected to grow at a constant rate of 5 percent a year. The investors’ required rate of return on the stock is 15 percent. What should be the appropriate value of the common stock?
SOLUTION
Given,
Expected divide at the end of the year (D₁) = Rs 25
Constant growth rate (g) = 5%
Required rate of return (ks) = 15%
Value of common stock (Po) = ?
We know,
Po =D₁ / (Ks – g ) = 25 / 0.15-0.05
= Rs 250
The value of common stock is Rs 250
- 2072 Q.No, 8b
MT Company is expected to pay Rs 16 per share dividend at the end of the year. The dividend is expected to grow at a constant rate of 6 percent a year. The investors’ required rate of return on the stock is 14 percent. What should be the appropriate value of the common stock? SOLUTION
Given,
Expected dividend at the end of the year (D₁) = Rs 16
Growth rate (g) = 6%
Required rate of return (ks) = 14%
Value of common stock (Po) = ?
We know,
Po =D₁ / (Ks – g ) = 16 / 0.14-0.06
= Rs 200
Value of common stock (Po) = Rs 200
1. What are the characteristic features of preference share?
Preferred stock is a hybrid security issued by companies. It is called hybrid security because it has some features common to debt and others similar to common stock. The rate of dividend to be paid on preferred stock is fixed and it generally has fixed maturity after which preferred stockholders are repaid. These features are similar to debt. Though preferred stock dividend is fixed, non-payment of preferred stock dividend does not lead the company into bankruptcy as in the case of common stock dividend payment. Some important features of preferred stock are as follows:
- Par value: Preferred stock has a stated par value. Par value shows the amount due to the preferred stockholders in the event of liquidation or maturity. The preferred stock dividend is paid as a percentage on par value.
- Fixed dividend: Preferred stockholders receive fixed dividends. However, a company can postpone the preferred stock dividend payment if it does not have sufficient profit.
- Maturity: Preferred stocks have specified maturity dates. On the expiry of maturity date preferred stockholders are repaid.
- Cumulative feature: Some preferred stocks are issued with cumulative features. It allows the unpaid dividend in any year to be cumulative and paid in the later year.
- Participating feature: Participating feature allows the preferred stockholders to participate with common stock in the residual earnings of the firm.
- Voting rights: Preferred stockholders do not have the voting right. However, they are given special voting rights if the company does not pay preferred stock dividends for a specified period.
- Claims on asset and income: Preferred stock has prior claim on assets and income than common stock but later claim than debt. h. Call feature: Call feature allows the issuer the right to call the preferred stock for redemption at a specified price before maturity date. However, the call price to be paid upon call is usually higher than par value.
- Conversion feature: A convertible preferred stock can be converted into a specified number of common stocks at the holders’ desire within a specified period of time.
- Adjustable-Rate and Payment-in-kind Preferred Stock: Adjustable rate preferred stocks have a dividend rate that is tied to the interest rates on specific government securities. Payment-in-kind preferred stock pays dividend in the form of additional shares of preferred stock or in kind instead of cash dividend.