Chapter 12: Equity Financing and Securities Markets

Equity in For-Profit Businesses

  • For-profit businesses are usually organized as:

    • Sole Proprietors.

    • Partnerships.

    • Corporations.

    • Hybrid forms.


Stockholders’ Rights and Privileges

  • Stockholders have a claim on the residual earnings (net income) of the business:

    • Net income “belongs” to shareholders.

    • Some portion may be paid out as dividends or used for stock repurchases.


  • Control of the firm.

  • Preemptive right.



Stock Returns Example

  • For dividend-paying corporations, stockholder returns consist of both dividends (all years) and capital gains (2005 to 2006) or losses (2007 to 2008).


  • Generally, the amount of dividend paid is constrained by the amount of earnings.


  • Occasionally, however, dividends may exceed earnings, because cash flow is more important than earnings in setting dividend payments.



Methods Used by Corporations to Sell New Shares of Common Stock

  • Rights offering.

  • Public offering.

  • Private placement.

  • Employee stock purchase plan.

  • Dividend reinvestment plan (DRIP).

  • Direct purchase plan.


Equity in Not-for-Profit Businesses

  • NFP businesses must have “equity” capital, but it is not supplied by stockholders.


  • Start-up equity comes from:

    • Religious organizations.

    • Governmental entities.

    • Contributions.


  • Ongoing equity comes from:

    • Profits.

    • Contributions.

    • Grants.


Common Stock Valuation

  • For valuation, for-profit companies can be classified into three categories:

    • Start-up businesses, which can be valued (roughly) by option pricing models.

    • Young businesses, which can be valued on the basis of their expected operating cash flows.

    • Mature businesses, which can be valued on the basis of their expected dividend stream.


    • In the dividend valuation model, the value of a share of stock is the present value of the expected cash flow stream to shareholders.


    • In general, this stream consists of dividends and a future selling price.


    • Regardless of the holding period, a share of stock can be valued solely on the basis of its future dividend stream.



Constant Growth Model

  • If dividends are expected to grow at a constant rate forever, then the general

    stock valuation model can be simplified to this form:



  • E(P0) is the value of the stock. (P0 is the current price).


  • E(g) is the expected constant dividend growth rate.


  • R(Re) is the stock’s required rate of return.


  • D0 is the last dividend paid (assumed to be paid yesterday).


  • E(D1) is the next expected dividend (assumed to be received in one year).


The most uncertain input variables are the most subjective.


  • Four assumptions are necessary for this constant growth model:

    • E(g1) = E(g2) = E(gN) = E(g)

    • R(Re) > E(g)

    • The last dividend was paid recently.

    • Dividends are paid annually.



  • Dividend growth is caused primarily by:

    • Inflation.

    • Earnings retention.


  • Note that the model can be used when E(g)= 0 (zero growth) or when growth is negative.



Constant Growth Model

  • If dividends are expected to grow at a constant rate forever, then the general stock valuation model can be simplified to this form:


Constant Growth Stock Conditions

  • The dividend is expected to grow at a constant rate forever.


  • The stock price is expected to grow at the same rate.


  • The expected dividend yield is constant over time.


  • The expected capital gains yield is a constant equal to the growth rate.


Nonconstant Growth Model

  • Clearly, most “real world” dividend-paying stocks do not exhibit constant growth.


  • A somewhat more complicated model is required to value such stocks.


  • However, because of the uncertainties in the inputs required for stock valuation, the constant growth model is useful for many mature firms.


Security Market Equilibrium

  • Investors will buy a security when its:

    • Expected rate of return exceeds the required rate of return.

    • Expected value exceeds the current price.


  • In market equilibrium:

    • E(Re) = R(Re)

    • P0 = E(P0)


  • Efficient Markets - Buying and selling actions continuously move security prices towards equilibrium


Informational Efficiency

  • A market is informationally efficient if:

    • Relevant information about asset values can be easily obtained at low cost.

    • The market contains many buyers and sellers who act on the information.


Implications of Market Efficiency

  • Prices reflect all publicly available information.


  • Investors should not expect to “beat the market”:

    • In the short run, expect to earn average returns for the risk assumed.

    • In the long run, expect to earn returns that are commensurate with the risk assumed.


Why might the major stock and bond markets be efficient?

  • Major financial firms, such as Merrill Lynch, Fidelity Investments, and Prudential Insurance, have thousands of well-qualified analysts with immediate access to information along with billions of dollars to invest


  • Thus, new information is almost instantaneously reflected in current prices.


What markets are efficient?

  • In general, the markets for the stocks and bonds of large companies and for Treasury securities are efficient


  • However, there is evidence that “pockets of inefficiency” exist and that “emotional excesses” can distort values.


  • The markets for real assets (real estate, MRIs, and so on) are not efficient.


Risk/Return Trade-Off

  • In efficient markets, the only way to obtain a higher return is to assume more risk


  • Consider the following investment alternatives:

    ⚫The stock of Kindred Healthcare, the United States’ largest provider of post-acute services.

    ⚫Kindred’s bonds