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Summary Finance 2
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Week 1 : Chapter 9 and 12Chapter 9
All dividends are paid at the end of the year, we have the following timeline for this
investment:
Discount cash flows based on the equity cost of capital, r(e) for the stock = expected return
of other investments available in the market with equivalent risk to the firm’s shares.
→ willing to buy
→ willing to sell
The expected total return of the stock should equal the expected return of other investments
available in the market with equivalent risk.
● Stock’s dividend yield = expected annual dividend of the stock divided by its current
price.
● The dividend yield = percentage return the investor expects to earn from the dividend
paid by the stock.
● The sum of the dividend yield and the capital gain rate = total return is the expected
return that the investor will earn for a one-year investment in the stock.
→ the value of the firm depends on the dividend level for the
coming year, divided by the equity cost of capital adjusted by the expected growth rate of
dividends.
Firm can increase its dividend in three ways:
1. Increase its earnings (net income).
2. Increase its dividend payout rate.
3. It can decrease its shares outstanding.
New investment equals earnings multiplied by the firm’s retention rate = fraction of
current earnings that the firm retains:
New Investment = Earnings * Retention Rate
If the firm chooses to keep its dividend payout rate constant, then the growth in dividends
will equal growth of earnings:
g = Retention Rate * Return on New Investment
,Sustainable growth rate = rate at which it can grow using only retained earnings.
Cutting the firm’s dividend to increase investment will raise the stock price if, and only if,
the new investments have a positive NPV.
We cannot use the constant dividend growth model to value the stock of such because:
1. These firms often pay no dividends when they are young.
2. Their growth rate continues to change over time until they mature.
● Total payout model = allows us to ignore the firm’s choice between dividends and
share repurchases.
→Discount total dividends and share repurchases and use the growth rate of total
earnings (rather than earnings per share) when forecasting the growth of the firm’s
total payouts. More reliable and easier to apply when the firm uses share
repurchases.
● Discounted free cash flow model =focuses on the cash flows to all of the firm’s
investors, both debt and equity holders, allowing us to avoid estimating the impact of
the firm’s borrowing decisions on earnings.
trailing earnings = earnings over the prior 12 months
In an efficient market, investors will not find positive-NPV trading opportunities without some
source of competitive advantage. By contrast, the average investor will earn a fair return on
his or her investment. In an efficient market, to raise the stock price corporate managers
should focus on maximizing the present value of the free cash flow from the firm’s
investments, rather than accounting consequences or financial policy.
Chapter 12
The Capital Asset Pricing Model (CAPM) provides a practical way to identify an investment
with similar risk. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio
representing the non-diversifiable risk in the economy.
, A portfolio like the market portfolio, in which each security is held in proportion to its market
capitalization = value-weighted portfolio.
Value-weighted portfolio is also an equal-ownership portfolio: We hold an equal fraction of
the total number of shares outstanding of each security in the portfolio.
Because very little trading is required to maintain it, a value-weighted portfolio is also a
passive portfolio.
A price-weighted portfolio holds an equal number of shares of each stock, independent of
their size.
Beta corresponds to the slope of the best-fitting line in the plot of the security’s excess
returns versus the market excess return.
Debt cost of capital = cost of capital that a firm must pay on its debt.
The importance of these adjustments will naturally depend on the riskiness of the bond,
with lower-rated (and higher-yielding) bonds having a greater risk of default.
Most common method for estimating a project’s beta is to identify comparable firms in the
same line of business as the project we are considering undertaking. Indeed, the firm
undertaking the project will often be one such comparable firm. Then, if we can estimate the
cost of capital of the assets of comparable firms, we can use that estimate as a proxy for the
project’s cost of capital.
If the firm’s average investment has similar market risk to our project, then we can use the
comparable firm’s equity beta and cost of capital as estimates for beta and the cost of capital
of the project.
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