I.

DIFFERENCES BETWEEN DEBT AND EQUITY CAPITAL

DEBT includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. obtained from creditors EQUITY consists of funds provided by the firms owners (investors or stockholders) and is repaid subject to the firms performance obtained from investors who then become part owners of the firm can be obtained internally or externally

A. VOICE IN MANAGEMENT
Unlike creditors, holders of equity (stockholders) are owners of the firm. Stockholders generally have voting rights that permit them to select the firms directors and vote on special issues. In contrast, debtholders do not receive voting privileges but instead rely on the firms contractual obligations to them to be their voice.

B. CLAIMS ON INCOME AND ASSET

Their (equity) claims on income cannot be paid until the claims of all creditors, including both interest and scheduled principal payments, have been satisfied. Claims on assets: If the firm fails, its assets are sold, and the proceeds are distributed in this order: secured creditors, unsecured creditors, and equityholders.

C. MATURITY
Unlike debt, equity is a permanent form of financing for the firm. It does not mature, so repayment is not required. Because equity is liquidated only during bankruptcy proceedings, stockholders must recognize that, although a ready market may exist for their shares, the price that can be realized may fluctuate. This fluctuation of the market price of equity makes the overall returns to a firms stockholders even more risky.

D. TAX TREATMENT
Interest payments to debtholders are treated as tax-deductible expenses by the issuing firm, whereas dividend payments to a firms stockholders are not tax deductible.

II.

PREFERRED AND COMMON STOCK

A firm can obtain equity capital by selling either common or preferred stock. Although both common and preferred stock are forms of equity capital, preferred stock has some similarities to debt that significantly differentiate it from common stock.

A. COMMON STOCK
Ownership The common stock of a firm can be privately owned by private investors or publicly owned by public investors. Private companies are often closely owned by an individual investor or a small group of private investors (such as a family). Public companies are widely owned by many unrelated individual or institutional investors. Par Value The market value of common stock is completely unrelated to its par value. The par value of common stock is an arbitrary value established for legal purposes in the firms corporate charter and is generally set quite low, often an amount of $1 or less. Preemptive Rights The preemptive right allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of their ownership. Authorized, Outstanding, and Issued Shares A firms corporate charter indicates how many authorized shares it can issue. The firm cannot sell more shares than the charter authorizes without obtaining approval through a shareholder vote. To avoid later having to amend the charter, firms generally attempt to authorize more shares than they initially plan to issue. Authorized shares become outstanding shares when they are issued or sold to investors. If the firm repurchases any of its outstanding shares, these shares are recorded as treasury stock and are no longer considered to be outstanding shares. Issued shares are the shares of common stock that have been put into circulation; they represent the sum of outstanding shares and treasury stock. Voting Rights Generally, each share of common stock entitles its holder to one vote in the election of directors and on special issues. Votes are generally assignable and may be cast at the annual stockholders meeting. Dividends The payment of dividends to the firms shareholders is at the discretion of the companys board of directors. Most corporations that pay dividends pay them quarterly. Dividends may be paid in cash, stock, or merchandise. Cash dividends are the most common, merchandise dividends the least.

B. PREFERRED STOCK
Preferred stock gives its holders certain privileges that make them senior to common stockholders. Preferred stockholders are promised a fixed periodic dividend, which is stated either as a percentage or as a dollar amount. How the dividend is specified depends on whether the preferred stock has a par value. Par-value preferred stock has a stated face value, and its annual dividend is specified as a percentage of this value. No-par preferred stock has no stated face value, but its annual dividend is stated in dollars.

Preferred stock is most often issued by public utilities, by acquiring firms in merger transactions, and by firms that are experiencing losses and need additional financing. Basic Rights of Preferred Stockholders The basic rights of preferred stockholders are somewhat stronger than the rights of common stockholders. Preferred stock is often considered quasi-debt because, much like interest on debt, it specifies a fixed periodic payment (dividend). Preferred stock is unlike debt in that it has no maturity date. Because they have a fixed claim on the firms income that takes precedence over the claim of common stockholders, preferred stockholders are exposed to less risk. Restrictive Covenants - The restrictive covenants in a preferred stock issue focus on ensuring the firms continued existence and regular payment of the dividend. Cumulation - Most preferred stock is cumulative with respect to any dividends passed. That is, all dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders. If preferred stock is noncumulative, passed (unpaid) dividends do not accumulate. Other Features - Preferred stock can be callable or convertible.

C. ISSUING COMMON STOCK

Venture Capital The initial external equity financing privately raised by firms, typically early stage firms with attractive growth prospects, is called venture capital. Those who provide venture capital are known as venture capitalists (VCs). They typically are formal business entities that maintain strong oversight over the firms they invest in and that have clearly defined exit strategies. Less visible early-stage investors called angel capitalists (or angels) tend to be investors who do not actually operate as a business; they are often wealthy individual investors who are willing to invest in promising early-stage companies in exchange for a portion of the firms equity. Venture capital investors tend to be organized in one of four basic ways. The VC limited partnership is by far the dominant structure. These funds have as their sole objective to earn high returns, rather than to obtain access to the companies in order to sell or buy other products or services. Organization of Venture Capital Investors Small business Corporations chartered by the federal government that can borrow at investment companies attractive rates from the U.S. Treasury and use the funds to make (SBICs) venture capital investments in private companies. Financial VC funds Subsidiaries of financial institutions, particularly banks, set up to help young firms grow and, it is hoped, become major customers of the institution.

Corporate VC funds

Firms, sometimes subsidiaries, established by nonfinancial firms, typically to gain access to new technologies that the corporation can access to further its own growth. Limited partnerships organized by professional VC firms, which serve as the general partner and organize, invest, and manage the partnership using the limited partners funds; the professional VCs ultimately liquidate the partnership and distribute the proceeds to all partners.

VC limited partnerships

Going Public When a firm wishes 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. Initial public offering (IPO) is the first public sale of a firms stock. IPOs are typically made by small, rapidly growing companies that either require additional capital to continue expanding or have met a milestone for going public that was established in a contract signed earlier in order to obtain VC funding. Investment Banker An investment banker is a financial intermediary that specializes in selling new security issues and advising firms with regard to major financial transactions. Most public offerings are made with the assistance of an investment banker. The main activity of the investment banker is underwriting. Underwriting is the role of the investment banker in bearing the risk of reselling, at a profit, the securities purchased from an issuing corporation at an agreed-on price.

In the case of very large security issues, the investment banker brings in other bankers as partners to form an underwriting syndicate. The syndicate shares the financial risk associated with buying the entire issue from the issuer and reselling the new securities to the public. The originating investment banker and the syndicate members put together a selling group, normally made up of themselves and a large number of brokerage firms. Each member of the selling group accepts the responsibility for selling a certain portion of the issue and is paid a commission on the securities it sells.

III.

COMMON STOCK VALUATION A. MARKET EFFICIENCY

In competitive markets with many active participants, the interactions of many buyers and sellers result in an equilibrium pricethe market valuefor each security. This price reflects the collective actions that buyers and sellers take on the basis of all available information. Buyers and sellers digest new information quickly as it becomes available and, through their purchase and sale activities, create a new market equilibrium price. Because the flow of new information is almost constant, stock prices fluctuate, continuously moving toward a new equilibrium that reflects the most recent information available. This concept is known as market efficiency.

B. THE EFFICIENT-MARKET HYPOTHESIS

The efficient-market hypothesis (EMH), which is the basic theory describing the behavior of such a perfect market, specifically states that 1. Securities are typically in equilibrium, which means that they are fairly priced and that their expected returns equal their required returns. 2. At any point in time, security prices fully reflect all information available about the firm and its securities, and these prices react swiftly to new information. 3. Because stocks are fully and fairly priced, investors need not waste their time trying to find mispriced (undervalued or overvalued) securities. Not all market participants are believers in the efficient-market hypothesis. Some feel that it is worthwhile to search for undervalued or overvalued securities and to trade them to profit from market inefficiencies. Others argue that it is mere luck that would allow market participants to anticipate new information correctly and as a result earn abnormal returnsthat is, actual returns greater than average market returns. Behavioral Finance Although considerable evidence supports the concept of market efficiency, a growing body of academic evidence has begun to cast doubt on the validity of this notion. The research documents various anomalies outcomes that are inconsistent with efficient marketsin stock returns. A number of academics and practitioners have also recognized that emotions and other subjective factors play a role in investment decisions. This focus on investor behavior has resulted in a significant body of research, collectively referred to as behavioral finance. Advocates of behavioral finance are commonly referred to as behaviorists.

C. PREFERENCE SHARE CAPITAL VALUATION

The value of preference share capital is the present worth of a series of equal cash flow streams (dividends), continuing indefinitely. Since the dividends in each period are equal for preference shares, the valuation model is: V= where V = present value of a preference share D = annual dividend r = the investors required rate of return

D. CALCULATING EXPECTED RETURN ON PREFERENCE SHARE CAPITAL

The valuation model for computing the expected rate of return on preference share capital is: r= where r = the expected rate of return on preference share capital D = annual dividend V = present value of a preference share

E. BASIC COMMON STOCK VALUATION EQUATION

Basic Valuation Method The value of shares of common stock, like any other financial instrument, is often understood as the present value of expected future returns. Again we return to the discounted cash flow formula

-This DCF formula leads to two particularized formulas in situations of zero growth and constant growth. Valuation Methods

1. Zero Growth Model

The simplest DCF model assumes constant dividends -- zero growth. In this artificial world (no inflation, no variation, no change) the present value of a constant dividend stream is the present value of a perpetuity:

2. Constant-Growth Method/Gordon Model

This model makes heroic assumptions about the flat continuity of growth, that extrapolation from past dividends reflects likely future earnings, and the stock's risk can be reflected in a single discount rate. Such is valuation!

3. Variable Growth Model

Step 1 Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 through N. This step may require adjusting the most recent dividend, D0, using the initial growth rate, g1, to calculate the dividend amount for each year. Therefore, for the first N years,
Dt = D0 * (1 + g1)t

Step 2 Find the present value of the dividends expected during the initial growth period. Using the otation presented earlier, we can give this value as

Step 3 Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs - g2), which is the present value of all dividends expected from year N + 1 to infinity, assuming a constant dividend growth rate, g2. This value is found by applying the constant-growth model

Step 4 Add the present value components found in Steps 2 and 3 to find the value of the stock, P0, given in Equation 7.5:

Valuing Ordinary Share Capital The value of the ordinary share capital is the present value of all future cash inflows expected to be received by the investor, including dividends and the future price of the share at the time it is sold.

4. Single Holding Period

For an investor holding an ordinary share for only one year, the value of the share is computed as: Where: P0 - value of ordinary share D1 - expected cash dividend P1 - expected market price share r - rate of return

5. Multiple Holding Period

For an investor holding an ordinary share for multiple year, the value of the share is computed as: If dividend is classified as Zero Growth: Where: P0 - value of ordinary share D - expected cash dividend r - rate of return

This model is most applicable to the valuation of preference shares or to the ordinary shares of very mature companies, such as large utilities. If dividend is classified as Constant Growth: Where: P0 - value of ordinary share D1 - dividends D0(1+g) g - growth rate r - rate of return

This formula, known as Gordons Valuation Model, is most applicable to the valuation of the ordinary share of very large or broadly diversified firms.

F. CALCULATING THE EXPECTED RETURN ON ORDINARY SHARE CAPITAL

The formula for computing the expected rate of return on ordinary share capital can be derived from the valuation models. Single Holding Period Where: P0 - value of ordinary share D1 - expected cash dividend P1 - expected market price share r - rate of return

Multiple Holding Period If dividend is classified as Zero Growth: Where: P0 - value of ordinary share D - expected cash dividend r - rate of return

If dividend is classified as Constant Growth: Where: P0 - value of ordinary share D1 - dividends D0(1+g) g - growth rate r - rate of return

G. FREE CASH FLOW VALUATION MODEL

A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firms weighted average cost of capital, which is its expected average future cost of funds over the long run. The formula in computing the common stock using the free cash flow valuation model is:

Where: Vs value of the common stock Vc vaue of the entire company VD market value of all debt VP market value of preferred stock To know the process of Free Cash Flow Valuation Model, lets take an example. Example: Dewhurst, Inc., wishes to determine the value of its stock by using the free cash flow valuation model. Data for valuation are the following: (NEXT PAGE)

Step 1: Calculate the present value of the free cash flow occurring from the end of 2018 to infinity.

Step 2: Add the present value of the FCF from 2018 to infinity, to the 2017 FCF value to get the total FCF in 2017.

Step 3: Find the sum of the present values of the FCFs for 2013 through 2017 to determine the value of the entire company, VC.

Step 4: Calculate the value of the common stock, Vs.

The value of Dewhursts common stock is therefore estimated to be $4,726,426. By dividing this total by the 300,000 shares of common stock that the firm has outstanding, we get a common stock value of $15.76 per share ($4,726,426 divided by 300,000).

H. OTHER APPROACHES TO COMMON STOCK VALUATION

Many other approaches to common stock valuation exist. The more popular approaches include book value, liquidation value, and some type of price/ earnings multiple.

1. Book Value
Book value per share is simply the amount per share of common stock that would be received if all of the firms assets were sold for their exact book (accounting) value and the proceeds remaining after paying all liabilities (including preferred stock) were divided among the common stockholders. This method lacks sophistication and can be criticized on the basis of its reliance on historical balance sheet data. It ignores the firms expected earnings potential and generally lacks any true relationship to the firms value in the marketplace.

2. Liquidation Value
Liquidation value per share is the actual amount per share of common stock that would be received if all of the firms assets were sold for their market value, liabilities (including preferred stock) were paid, and any remaining money were divided among the common stockholders. This measure is more realistic than book value because it is based on the current market value of the firms assetsbut it still fails to consider the earning power of those assets. An example will illustrate.

3. Price/Earnings (P/E) Multiples

The price/earnings (P/E) ratio, introduced in Chapter 3, reflects the amount investors are willing to pay for each dollar of earnings. The average P/E ratio in a particular industry can be used as a guide to a firms value if it is assumed that investors value the earnings of that firm in the same way they do the average firm in the industry. The price/earnings multiple approach is a popular technique used to estimate the firms share value; it is calculated by multiplying the firms expected earnings per share (EPS) by the average price/earnings (P/E)

ratio for the industry. The average P/E ratio for the industry can be obtained from a source such as Standard & Poors Industrial Ratios.

IV.

DECISION MAKING AND COMMON STOCK VALUE

Although the required return, rs, is the focus of Chapters 8 and 9, at this point we can consider its fundamental components. Any measure of required return consists of two components, a risk-free rate and a risk premium. We expressed this relationship as Equation 6.1 in the previous chapter, which we repeat here in terms of

In the next chapter you will learn that the real challenge in finding the required return is determining the appropriate risk premium. In Chapters 8 and 9 we will discuss how investors and managers can estimate the risk premium for any particular asset. For now, recognize that rs represents the minimum return that the firms stock must provide to shareholders to compensate them for bearing the risk of holding the firms equity. Any action taken by the financial manager that increases the risk shareholders must bear will also increase the risk premium required by shareholders, and hence the required return. Additionally, the required return can be affected by changes in the risk free rateeven if the risk premium remains constant. For example, if the riskfree rate increases due to a shift in government policy, then the required return goes up too.

COMBINED EFFECT
A financial decision rarely affects dividends and risk independently; most decisions affect both factors often in the same direction. As firms take on more risk, their shareholders expect to see higher dividends. The net effect on value depends on the relative size of the changes in these two variables.