Bangladesh University of Business & Technology (BUBT)
FIN 2101: Principles of Business Finance
Chapter 7 - Stock Valuation
● Debt vs Equity
● Stock vs Share
● Common Stock
● Preferred Stock
● Issuing Common Stock
● Common Stock Valuation
● Related Mathematical Problems
Debt vs Equity
Debt financing involves borrowing money, typically through loans or bonds, which must be
repaid over time with interest. Creditors do not gain ownership in the company and have no
control over business operations, but they have a legal claim on assets in case of bankruptcy.
Debt is tax- deductible, making it a potentially cheaper option, but it increases financial risk due
to required interest payments.
Equity financing, by contrast, involves selling ownership shares to investors. Shareholders gain
partial ownership and voting rights, and they receive returns through dividends and capital gains.
Unlike debt, equity does not require repayment, easing cash flow pressure, but it dilutes existing
ownership and can be costlier in the long run if the business becomes highly profitable.
The choice between debt and equity affects a firm’s control, risk profile, financial flexibility, and
long-term strategy.
Stock vs Share
Particular Stock Share
A general term representing A specific unit of ownership in a particular
Definition ownership in one or more company.
companies.
Used to describe ownership broadly Used to describe specific holdings (e.g., "She
Usage (e.g., "He owns stock"). owns 100 shares of Apple").
Vague; doesn’t specify how much Precise; refers to a defined number of units.
Quantity ownership.
Company Can refer to ownership in multiple Always refers to ownership in a particular
Specificity companies. company.
Can refer to common or preferred Can be qualified further: “100 common
Types stock. shares of XYZ Corp.”
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Common Stock
Common stock represents ownership in a corporation and a claim on a portion of the company's
profits. Shareholders typically have voting rights, allowing them to vote on major corporate
decisions (e.g., electing the board of directors).
Key Features:
Voting rights: Usually one vote per share.
Dividends: Not guaranteed and can vary depending on company performance.
Residual claim: In case of liquidation, common shareholders are paid after debt holders
and preferred shareholders.
Capital appreciation: Common shareholders benefit most when the company grows and
the stock price increases.
Advantages:
Potential for high returns through capital gains.
Voting rights provide influence over management decisions.
Limited liability for shareholders.
Disadvantages:
Dividends are not guaranteed.
Higher risk due to last claim on assets in liquidation.
Price volatility in the stock market.
Preferred Stock
Preferred stock is a type of equity that has characteristics of both equity and debt. It offers
shareholders a fixed dividend and has priority over common stock in dividend payments and
asset claims during liquidation.
Key Features:
Fixed dividends: Paid before common stock dividends, often at a set rate.
No voting rights: Generally, preferred shareholders do not vote (unless specified).
Priority in liquidation: Ranked above common stock but below debt.
Convertible option: Some preferred shares can be converted into common shares.
Callable feature: Companies can repurchase preferred stock after a certain date.
Advantages:
More stable income due to fixed dividends.
Priority in receiving dividends and claims on assets.
Lower risk compared to common stock.
Disadvantages:
Limited capital appreciation.
Typically, no voting rights.
Potential callable feature may limit long-term returns.
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Issuing Common Stock
Typically, the initial nonfounder financing for business startups with attractive growth prospects
comes from private equity investors. Then, as the firm establishes the viability of its product or
service offering and begins to generate revenues, cash flow, and profits, it will often “go public” by
issuing shares of common stock to a much broader group of investors.
Venture Capitalists (VCs): Providers of venture capital; typically, formal businesses that maintain
strong oversight over the firms they invest in and that have clearly defined exit strategies.
Angel Capitalists (Angels): Wealthy individual investors who do not operate as a business but invest
in promising early-stage companies in exchange for a portion of the firm’s equity.
Initial Public Offering (IPO): The first public sale of a firm’s stock. When a firm is to sell its stock
in the primary market, it has three alternatives. It can make (1) a public offering, in which it offers its
shares for sale to the general public; (2) a rights offering, in which new shares are sold to existing
stockholders; or (3) a private placement, in which the firm sells new securities directly to an investor
or group of investors.
Common Stock Valuation
1. Constant Growth Dividend Discount Model (Gordon Growth Model)
𝑃0 = Current stock price
Where:
𝐷1 = Expected dividend next year
r = Required rate of return
g = Constant dividend growth rate
2. Zero Growth (No Growth) Dividend Model
Where:
D = Fixed annual dividend
𝑃0 = Value of the stock
r = Required rate of return
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3. Negative Growth Dividend Discount Model
But: g is negative
4. Total Rate of Return (Investor’s Perspective)
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Problem 1: You are a financial analyst for Elite Investment Company, and you are looking for
undervalued securities. After searching the market, you identify Stock A and Stock B as potential
purchases. Stock A is currently selling at $100 with an expected dividend of $6 and constant growth
rate of 5%, while Stock B is a preferred stock, currently selling at $60 with a $5 dividend paid each
year. Answer the following questions on the basis that you believe the required rates of return for
both stocks should be 10%:
a. How much would you pay for Stock A?
b. How much would you pay for Stock B?
c. Which security is undervalued? Why?
Problem 2: Ray Steel Company is a mature manufacturing company. The company just paid a $5
dividend and management wants to cut future dividends, reducing them by 2% each year
indefinitely. If you require an 8% return on this stock, how much will you pay for it?
Problem 3: Nick is a security analyst in an investment banking firm. His supervisor asked him to
evaluate a preferred stock. The par value of the preferred stock is $100 and it pays an annual
dividend of $5.30 per share. Answer the following questions on the basis that the market required
return is 7%.
a. What is the market value of the preferred stock?
b. Suppose an investor purchased the preferred stock today, held it for one year, and sold it
upon receiving the dividend. If the market required return is 8% when he sold the preferred
stock, what is the investor’s total rate of return?
Problem 4 Sweet Candy will pay a dividend of $0.72 next year. The CEO of the company declared
that the company will maintain a constant growth rate of 7% per year every year from now on.
a. How much will you pay for the stock if your required return is 10%?
b. How much will you pay for the stock if your required return is 8%?
c. Based on your answer in parts a and b, give one disadvantage of the constant growth model.
Problem 5: The common stock of Denis and Denis Research, Inc., trades for $60 per share.
Investors expect the company to pay a $3.90 dividend next year, and they expect that dividend to
grow at a constant rate forever. If investors require a 10% return on this stock, what is the dividend
growth rate that they are anticipating?
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