Cost of Capital

Equity- Residual Interest

Cost of Capital- (must be lower than Rate of Return to be acceptable)
- Cost of using the funds
- Capital Budget Purposes/ Investment Purposes
- Basis to consider if project budget is acceptable.

Overestimation of Cost of Capital—can make the project unattractive.

Underestimation of Cost of Capital—can make the project attractive, even if it is not.

Sources of Capital Cost of Capital

Debt Securities (Bonds)—cheapest. Interest Rate (1-Tax Rate)
- Interest Expense is deductible - Nominal and Effective
expense causing Tax Liability to lower. - Use EFFECTIVE
- If you are a bond holder you can - If there is only one interest rate,
always enforce what is due to you, nominal rate should be used as
with or without income. (Lower risk effective.
for bond holder)
Share of Stocks
Preferred Shares
- Fixed rate dividends (cumulative and Dividend per Share(expected)
non-cumulative)
- Prioritized over ordinary shares.
Market Price per Share(net of FC )

Floatation Costs (FC)—cost incurred in

issuance of shares.
Ordinary Shares Dividends per Share(expected )
- True owner of business with voting + Growth rate
Market Price per Share(net of FC )
rights
- Holders can get Dividends and or
Capital Gains Yield (Increase in Share Earning per Share
of Stock Value) Market Price per Share(net of fc)

Retained Earnings Dividends per Share(expected )

- Same as Ordinary Share formula, but + Growth rate
Market Price per Share(net of FC )
no floatation cost because there is no
issuance of shares.

Combination of Sources of Capital—compute Weighted Average Cost of Capital (WACC)

Optimal Capital Structure

- Structure of equity and debt security to minimize the cost of capital.
- Decided and evaluated by the management.
- Whatever will be the decision of the management with ratio should be followed by the
company.
 70% Debt | 30% Equity = Highly risky (entity is required to pay interest even if there was
no profit for the year, hence it should be balanced.)

Objective of Management
- To maximize the shareholder’s wealth (profit does not equate to increase in value of
shares).
- Because in the case of accrual, there is a chance that profit is high but there is an
underlying problem with the cashflow.

Cost of Capital
Debt Interest (effective) (1-tax)
Ordinary Shares Dividend Expected
+Growth Rate
Market Price−FloatationCost
Preferred Shares Dividend Expected
Market Price−FloatationCost
Retained Earnings Dividend Expected
+Growth Rate
Market Price−FloatationCost
Weighted Average of Cost of Cost of Capital (each) x Allocation % = xx (total for each
Capital source of capital)
Discounted Cash Flow (DCF) Dividend per Share
+ Growth
Selling Price
Capital Asset Pricing Model Risk Free Rate + (Ave. Return-Risk Free Rate) (beta)
Bond Yield + Risk Premium (Ave. Return-Risk Free Rate) + Bond Yield
Stock Valuation
Value per Stock DI
Po =
r −g o
FCF
Po =
r −g
FCF
Po =
¿ Outstanding Shares
Rate of Return DI
r= +g
Po
Continuing Value
Last÷¿
¿
r −g
Last FCF
r−g
Intrinsic Value/ Firm Value Today
PVFI x Di = x
PVF2 x D 2= x
Last PVF x Cont. Value = x
Intrinsic Value/ Firm Value Today Pxx
 Effective Rate of Return Nominal Rate n−1
(1+ ¿ ¿ −1
n
r n −1
+ 1 x x −1
n
Leverage & Capital (Inc. Leverage = Inc. Return) = Highly Risky
Structure
Breakeven Point per Unit ¿ Cost
Selling Proce−Variable Cost
Degree of Operating Leverage Δ % EBIT
Δ % Sales
CM
EBIT
Degree of Financial Leverage Δ % EBT
Δ % EBIT
EBT
EBIT
Total Degree of Leverage Deg. of Operating Leverage x Deg. Of Financial Leverage
Sales Sales
(Variable Cost) (Variable Cost)
Contribution Margin Contribution Margin
(Fixed Cost) (Fixed Cost)
Profit EBIT
(Interest)
Net Income EBT
EBIT = (Tax)
1−Tax Rate
Earnings After Tax
÷ # Shares
Earnings Per Share
Optimal Structure Look at the Stock Price, it must be higher.
Dec. Cost of Cap. = Inc. Entity’s Stock Value
ROIC EBIT (1−Tax %)
Total Invested Capital
ROE Net Income
Ave .Total Equity
NI before Recapitalization [(EBIT) – Bef. Tax Cost of Debt x Issued Debt)] x 1-Tax%

Stock Valuation
How to determine the value of stock?
- To know and make the right decision when to buy and sell shares.

Ordinary Shares Preference Shares

- True owner with voting rights - From BUSCOM event
- Initial source of external financing - Priority in dividends and liquid assets
- Most Expensive - Fix rate
 - Leftovers from Creditors and - Cumulative and Non-cumulative
Preference Shares.
- Will have the remaining shares in case
of liquidation.
Expectations: Expectations:
- Dividends - Dividends Only
- Increase in value of Shares

2 Methods of Stock Valuation

1. Discounted Dividend Method
- Present value
- Use expected Dividends.
D1
a. Zero growth Model Po =
r
D1
b. Constant Growth Model Po =
r −g

2. Corporate Valuation Mode

- Use when the company is still not stable and has no capabilities to declare dividends.
- Basis: Free Cashflow—unrestricted or can be used without affecting the company
Value of Entity (less Debt Sec .∧Preference S .)
a. Value of Shares=
¿ of Outstanding Ordinary Shares

Legend
Po =Value of Stock
P1=Expected Value of Stock
D1=Dividend
D1=Expected Dividend
r =Rate of Return
g=Growth Rate

D1
Required Return (r) = +g
Po
D1
Growth rate (g) = r −
Po
Expected Value of Share ( P1) = Po (1+ g)

Different Sources of Financing

Debt Securities (Creditors) Equity Securities (Shareholders)
- Contractual - Ordinary Shares and Preference
- Expectation: Interest, whether there Shares
is a profit or none. - Expectation: Dividends, if there is a
 - No voting rights. profit and declaration only
- In case of liquidation: priority in - With voting rights
claims of liquid assets - In case of liquidation: what is left
- With maturity after the creditors.
- Tax treated as: deductible as expense - No maturity: long term financing
and income tax benefit - Tax Treated as: not deductible and
passive income.

Capital is obtained in three primary forms:

- Debt
- Preferred Stock
- Common Equity (with equity acquired by retaining earnings and issuing new stock.

The investors who provide capital expect to earn at least their required rate of return on that
capital, and the required return represents the firm’s cost of capital.

Factors that Influence the Cost of Capital

1. Interest rates
2. State and Federal Tax Policies
3. General Economic Conditions

Factors that Firm Cannot Control

1. Interest Rates in the economy—↑ IR ∈economy=↑ Cost of Debt , because firm must pay
bondholders more when they borrow.
2. General level of Stock Prices— stock prices∈ general ↓=↓ fir m ' s stock price , and cost
of equity ↑.
3. Tax Rates—as tax rates were lowered, stocks became more attractive than debt, the cost
of equity and WACC declined.

Capital comes from debt plus common equity, so its cost of capital depends largely on the level of
interest rates in the economy and the marginal stockholder’s required rate of return on equity.
Portfolio Risk—is a weighted average of the relevant risks of the different stocks in the portfolio.

Risk influences prices and required rates of return on bonds and stocks.

Objective—maximize its shareholder’s value.

Rates of return that investors require on bonds and stock represent the cost of these securities to
the firm.

The cost of capital must be lower than the rate of return.

Overview of the Weighted Average Cost of Capital (WACC)

- Capital must be provided by the investors—interest-bearing debt, preferred stock, and
common equity.
Market Value of Equity = # of shares outstanding * current stock price.

Target Capital Structure—mix of debt, preferred stock, and common equity the firm plans to
raise to funds its future project.
Optimal Capital Structure—the percentage of debts, preferred stock, and common equity
maximize the firm’s value.
Basic Definitions
Capital Components—One of the types of capital used by the firms to raise funds.
- Investor-supplied items—debt, preferred stock, and common equity.

SYMBOLS: IDENTIFY THE COST AND WEIGHT OF EACH

rd Interest rate of the firm’s new debt = before-tax component cost of
debt.
r d (1−T ) After-tax component cost of debt. T = Marginal tax rate.
Debt cost is used to calculate WACC.
After-tax cost of debt < Before-tax cost of debt, because interest is
tax deductible.
rp Preferred Stock, yield investors expect to earn on PS. PS is not tax
deductible, After-tax = Before-tax.
rs Common Equity raised by retained earnings or internal equity.
Obtained all of their new equity as RE, and common equity is the
cost of all new equity.
re Common Equity is raised by issuing new stock or external equity.
r e =r s +cost of issuing new stock
wd , wp , wc Target weights of debt, preferred stock, and common equity
(includes RE, Internal Equity, New Common Stock, and External
Equity)
WACC Firm’s weighted average or overall cost of capital.

WACC = (% of debt)(after-tax cod) + (% of PS)(cost of PS) + (% of com equity)(cost of com

equity)
 w d r d ( 1−T ) + w p r p +w c r p

Cost of Debt— r d (1−T )

Before-Tax Cost of Debt—interest rate that the firm must pay on new debt.
After-tax Cost of Debt—relevant cost of new debt, taking into account the tax deductibility of
interest; used to calculate the WACC.
- Interest rate on new debt less tax savings.
After-tax cost of debt = Interest Rate on new debt – tax savings
= r d (1−T )

After-Tax Cost of Debt is used in calculating WACC because of our interest in maximizing the value
of firm’s stock, and the price stock depends on after-tax cash flow.

Cost of Debt is the interest rate on new debt because its use in capital budgeting decision.

Cost of Preferred Stock, r p

Cost of Preferred Stock—rate of return investors requires on the firm’s preferred stock. No tax is
associated.
Dp
Component Cost of Preferred Stock = r d =
Pp
Cost of Retained Earnings, r s
Costs of Debt and Preferred Stock, based on the return that investors require on these securities.
Common Equity, based on the rate of return that investors require on the company’s common
stock.

New Common Equity is raised in two ways:

1. Retaining some of current year’s earnings
2. Issuing new common stock
r s=cost of retained earnings
r e =cosy of new common stock∨external equity

*Equity raised by issuing stock has a higher cost than equity from RE due to floatation costs
required to sell new common stock.

Cost of Retained Earnings—the rate of return required by stockholders on a firm’s common

stock.
Cost of New Common Stock—The cost of external equity; based on the cost of retained earnings
but increased for floatation costs necessary to issue new common stock.

Capital has opportunity costs:

- After-tax earnings = Stockholders
- Interest Payments = Bondholders
 - Preferred Dividends = Preferred Stockholders
- Net Earnings after payment of interest and PS = Common stockholders

*If firms cannot invest retained earnings to earn at least r s, it should pay those funds to its
stockholders and let them invest directly in stock or other assets that will provide return.

Required Rate of Return = Expected Rate of Return

D1
r s=r RF + RP= + g=r s
P0
Legend:
R(s) = Common Stock
R(RF) = Risk-free rate
RP = Risk Premium
D(1)/P(0) = expected return on stock
G = growth rate

Capital Asset Pricing Method (CAPM) Approach

Step 1: Estimate the risk-free rate. Uses 10-year treasury bond rate.
Step 2: Estimate the stock’s beta coefficient b i and use it as an index of stock’s risk.
Step 3: Estimate the market risk premium.
Market Risk Premium = Rate of Return – Risk Free Rate
Step 4: Substitute the preceding values in the CAPM equation to estimate the required rate of
return on the stock.
r s=r RF +(RPm )bi
r s=r RF +(r m−r RF )b i

Bond Yield Plus Risk Premium Approach

- If CAPM is not available, use subjective procedure to estimate the cost of equity. Risk
Premium on a firm’s stock over its own bonds generally ranges from 3%-5%
- Firms with risky, low-rated, and consequently high-interest rate debt also have risky,
high-cost equity, and the procedure of basing the cost of equity on the firm’s own readily
observable debt cost utilizes this logic.
r s=Bond Yield+ Risk Premium

Dividend Yield Plus Growth Rate or Discounted Cash Flow (DCF) Approach
Business Remains= cash flow are the dividends.
Be acquired or Liquidated = cash flow are the dividends + price at a horizon date when firm is
liquidated.
D1
Po =
¿¿
∞
D
¿∑ t ¿
t=1
¿ ¿
Legend:
P0 = Current Stock Price
D = Dividend
r s = Required Rate of Return

If dividends are expected to grow at a constant rate

D1
Po =
(r s −g)
To get the required rate of return on common equity, which for the marginal investor is also equal
to the expected rate of return.
D1
r s=r s = + Expected G
P0
Discounted Cashflow (DCF)—investors expect to receive a dividend yield, a capital gain for a
total expected return, and this return is also equal to the required return.

*If the growth rate is expected to not be constant, DCF can still be used to estimate the required
rate of return, but it is necessary to compute for average growth rate.

Averaging the Alternative Estimates—If firm has confidence on one method—use that
method’s estimate alone.

Cost of New Common Stock, r e

Firms use an investment banker when they issue new common stock and when they issue
preferred stock or bonds. Investment Bankers help the company structure the terms, set a price
for the issue, and sell the issue to investors.

Floatation Cost—banker’s fee and the total cost of the capital raised is the investors’ required
return plus the floatation cost.
Add Floatation Costs to a Project’s Costs
Capital budgeting Projects involves an initial cash outlay followed by a series of cash inflows.
Handling Approach:
- Found as the sum of Floatation Cost for the debt, preferred, and common stock used to
finance the project, is to add this sum to the initial investment.
Investment Cost ↑ = ↓ Rate of Return

Increase the Cost of Capital

Adjusting the cost pf capital rather than increasing the project’s investment costs.

Adjustment Process is based on:

- If there is a floatation cost the firm receives only a portion of the capital provided by the
investors and the remainder goes to the underwriter. Hence, to provide the investors with
their required rate of return, there must earn a higher rate of return than the investors’
required rate of return.
 - DCF is used to estimate the effects of floatation costs.

Floatation Cost—the percentage cost of issuing new common stock.

Floatation Cost Adjustment—the amount that must be added to RS to account for floatation
cost to find RE.
D1
Cost of equity from new stock = r s= + Expected G
P 0 (1−F)

*F = % Floatation Cost required to sell the new stock, net price per share received by the
company.

Floatation Cost Adjustment = Adjusted DCF Cost – Pure DCF Cost

Cost of External Equity = r s+ Floatation Cost

When be External Equity used?

- As floatation cost: Dollars raised by selling new stock must “work harder” than dollars
raised by retained earnings. As no floatation cost is involved, retained earnings cost less
than new stock.
- If firm has > good investment opportunities that can be financed with RE + debt and
preferred stock supported by RE, it may need to issue new common stock.

Retained Earnings Breakpoint—the amount of capital that can be raised before new stock must
be issued.
Retained Earnings Breakpoint =
Addition ¿ retained earnings for the year ¿
equity fraction

Factors that a Firm can Control.

1. Changing capital structure
o If a firm changes its target capital structure, the weights used to calculate the
WACC will change. An ↑ in target debt ratio tends to ↓ WACC, because the after-
tax cost of debt is lower than cost of equity.
2. Changing its dividend payout ratio
o A dividend policy affects the amount of retained earnings available to the firm,
thus the need to sell new stock and incur floatation costs.
o The higher the dividend payout ratio, the smaller the addition to retained
earnings, the higher cost of equity, and higher WACC.
3. Altering its capital budgeting decision rules to accept projects with more or less risk.
 o As we estimate the firm’s cost pf capital, we use the required riskiness of the
firm’s existing assets, hence, new capital will be invested in assets that have the
same risk as existing assets.
o Yet, if firms decided to invest in entirely new and risky lines of business,
component cost of debt and equity will increase.

Cost of capital is a key element in the capital budgeting process. Projects should be accepted if
estimated returns exceed their cos of capital.

Problems with Cost of Capital Estimates

1. Depreciation-Generated Funds
o The largest single source of capital is depreciation because depreciation cash
flow can either be reinvested or returned to investors. The cost of depreciation-
generated funds is an opportunity cost.
2. Privately owned firms
o Cost of Equity is focused on publicly owned corporations and concentrated on the
rate of return required by public stockholders. The issue lies on how to measure
the cost of equity of firms whose stock is not traded.
3. Measurement Problems
o It is just difficult to estimate the cost of equity.
4. Cost of Capital for projects of Different Tasks
o Projects differed in risk and required rates of return; it is difficult to measure a
project’s risk.
5. Capital Structure Weights
o Target Capital structure is used to calculate the WACC.

CHAPTER 9: BONDS AND THEIR VALUATION

Bond Investor, source of income—Periodic Fixed Coupon Cashflow.

 Capital Gains Yield—annual percentage change in the bond price.
 Yield to Maturity—total return of a bond.
o Comprises of Current Yields and Capital Gains Yield.
o Same as Interest Rate on Debt Securities
¿
o r d =r + IP+ MRP+ DRP + LP
Bonds
¿
a. Government Funds—r + IP + MRP
 b. Corporate Funds—DRP + LP (compensate for risk and illiquidity pf corporate bonds)
a. Investment-grade bonds
b. Non-investment Grade/ Junk Bonds—Higher risk.

↓ Bond Rate=↑ Interest Rate

Capital is raised through Debt and Equity.

Bonds
- Long-term contract/ Long-term debt instrument. For long-term debt capital.
- The borrower agrees to make payment of interest and principal.

a. Treasury Bonds/ Treasuries/ Government Bonds

o Issued by Federal Government.
o No default risk.
o ↑ Interest Rates = ↓ Bond Price
b. Corporate Bonds
o Issued by Business Firms
o Exposed to default risk/ Credit risk.
o ↑ Risk = ↑ Interest Rate demands
c. Municipal Bonds/ Munis
o Issued by State and Local governments.
o Exposed to some default risk but has major advantages.
o Interest earned is exempt from federal and state tax.
o Munis IR < Corporate Bond IR.
d. Foreign Bonds
o Issued by Foreign Government/ Foreign Corporation
o All are exposed to default risk.
o Risk: Bonds are denominated by currency.

Key Characteristics of Bonds

1. Par Value—stated face value of bond. Amount of money that borrows and promise to
repay on maturity date.
2. Coupon Interest Rate—specified/ fixed number of dollars of interest each year. Set as
bonds are issued.
a. Coupon Interest Rate—stated annual interest rate on a bond.
(Annual Coupon Payment ÷ Par Value)
b. Fixed-Rate Bonds—bonds whose interest rate is fixed for its entire life.
c. Floating-Rate Bonds—bonds whose interest rate fluctuates with shifts in the
general level of interest rates. (Coupon rate can change every now and then).
d. Zero-Coupon Bonds—bonds that pay no annual interest but are sold at discount
below par, compensate investors through Capital Appreciation.
 e. Original Issue Discount (OID) Bond—bonds are offered at a price below its par
value.
3. Maturity Date—specified date on which the par value must be repaid.
a. Original Maturity—# of years to maturity as bond is issued.
4. Call Provisions—issuer has the right to call the bonds for redemption. The issuer must
pay bondholders greater than par value.
a. Call Premium—additional sum to interest.
b. Deferred Call—have call protection, bonds are not callable for several years.
c. Refunding Operation—when the entity sells a new issue of low-yielding
security and the proceed is used to retire high-rate issue, interest expensed is
reduced. Beneficial to firms but detrimental to long-term investors.
5. Sinking Funds—retire a portion of the bond issued each year. Mandatory payment. No
call premium
6. Convertible Funds—bonds that are exchangeable into shares of common stock at fixed
price (option of bondholder). Offer chance for capital gains but enables lower coupon
rate.
7. Warrants—give a holder an option to buy stock for a stated price but carry a lower
coupon rate than other nonconvertible bonds.
8. Putable Bonds—right to retire the debt prior to maturity/ sell them back to company,
requires company to pay in advance.
9. Income Bonds—pays interest only if it is earned. Cannot bankrupt a company but riskier
than regular bonds on the part of investors.
10. Indexed/ Purchasing Power Bond—Interest rate is based on inflation index—
Consumer Price Index (CPI). ↑ Inflation Rate = ↑ Interest Rate.

Bonds Valuation
The value of a financial asset is the present value of the cash flows the asset is expected to
produce.
- r d —market rate of interest on the bond. This is the discount rate used to calculate the PV
pf cash flow and bond’s price.
- N—number of years before the bond matures.
- Interest Paid=Coupon Rate x Par Value
- M—the par/ maturity/ value of the bond. Paid at majority.

If bond market/ rate/ debt = coupon rate, a fixed rate bond will sell at its par value.
- ↑ Market Interest Rate = ↓ Bond Price
- ↓ Market Interest Rate = ↑ Bond Price
Discount Bond
- Interest Rate > Coupon Rate, Fixed-Rate Bond < Par Value.
- Bond that sells below its par value .
Premium Bond
- Interest Rate < Coupon Rate, Fixed-Rate Bond > Par Value
- Bond that sells above its par value.
r d = coupon rate, fixed-rate bond sells at par—par bond
r d > coupon rate, fixed-rate bond sells below par—discount bond
r d < coupon rate, fixed-rate bond sells above par—premium bond

Bonds Yield—give an estimate of rate of return.

Coupon Rate = Fixed ; Bond Yields = Varies
1. If bond is not callable, remaining life is the maturity.
2. If bond is callable, remaining life to maturity.

Yield to Maturity—rate of return earned on a bond if it is held to maturity.

- Bond’s promise rate of return—return that will receive if all promised payments were
made.
- Expected Rate of Return
a. The probability of default is 0.
b. Bonds cannot be called.
Yield to Call—rate of return earned on a bond when it is called before maturity date.
- If bonds are callable, the holder does not have the right to hold it until maturity. Yield to
Maturity will not be earned.
- Interest Rate < Bond’s Coupon Rate = Callable Bond, cause to estimate the Yield to Call
- N—number of years.
- Call price—price that must be paid to call the bond (Par Value + 1 year Interest)
- Company is more likely to call its bonds if they are able to replace their current high-
coupon debt with cheaper financing,
- Bond is called if Price > Par, because this means that Interest Rate < Coupon Rate.

Changes in Bond Values Over Time

A Coupon Bond is issued, it is generally set that causes Market Price = Par Value.

New Issue—bond that has been issued. Price close to par.

Outstanding Bond/ Seasoned Issue—once the bond is issued. Price varies from par.

Capital gains yield—Annual Change in Price ÷ Beginning Price.

Bonds Total Return = Current Yield + Capital Gains Yield

- In case of absence of default risk and market equilibrium, total return = yield to maturity
and market interest rate.

CHAPTER 10: STOCKS AND THEIR VALUATION

Value of Stock—PV of its future cashflow.

Stocks—Common Equity and Preferred Shares
Bonds—set by contract and easy to predict their cash flows.

Preferred Stock Dividends Common Stock Dividends

 - Set by contract. - Not contractual
- Easy to predict their cash flows. - Depending on firm’s earnings.
- Owners of the corporation
- Have rights and privileges.
- Right to elect directors

2 Methods of Stock Valuation

1. Discounted Dividend Model
2. Corporate Valuation Model
o Buy: Price < Est. Intrinsic Value
o Sell: Price > Est. Intrinsic Value
Proxy
- Transfer the right to vote.
- Document allowing one the authority to act for another. (Power to vote shares of common
stock.)

Proxy Fight
- Proxies overthrow the management and take control of business.
- Attempt to gain control and replace the current management.

Takeovers
- A group succeeds in ousting a firm’s management and taking control of the company.

Pre-emptive Right
- Purchase on pro-rata basis
- Give common stockholders the right to purchase on a pro-rata basis new issue of
common stock.
Purpose
- Prevents the management of a corporation from issuing a large number of additional
shares and purchasing those shares itself.
- To protect stockholders from a dilution value

Types of Common Stock

a. Classified Stock—to meet special needs.
b. Founder’s Shares—dual class shares, give special voting privileges to key insiders.
Criticize as this enables insider to make decisions that are counter to the interests of the
majority of stockholders. Stock owned by founder’s that enables them to maintain control
over the company without having to own the majority of the common stock.
Stock Price vs. Intrinsic Value
Stock Price—current market price and easily observed for publicly traded companies.
Intrinsic Value—true value of the company’s stock and is estimated.

Market Equilibrium—Stock Proce = Intrinsic Value

Goal in investing stock—purchase stock that is undervalued and avoid stocks that are
overvalued. Because investors care about intrinsic value.

Managers are concerned about Intrinsic Value:

a. Know how actions affect stock prices, models of intrinsic value help demonstrate the
connection between managerial decision and firm value.
b. Consider whether their stock is undervalued/ overvalued.

2 Models to Estimate Intrinsic Values

Discounted Dividend Model Corporate Valuation Model
- Focus on dividends. - Focuses on sales, costs, and free cash
- The Value of Common Stock depends flows.
on Cashflow.
a. Dividends received while holding
stock.
b. Dividends received when stock is
sold.

Final Price = Original Price Paid + Capital

Gain

Marginal Investor—determine the

equilibrium stock price.

Dt –Dividend expected to receive each year.

Forecast by marginal investor.
D0 –last dividend paid by company, w/
certainty.
D1 –first dividend to receive at year 1,
expected values.
D2—dividend expected in year 2, expected
values.
P0 –Actual market price, with certainty but
predicted prices are subject to uncertainty.
P1 –Expected price and expected intrinsic
value of stock at the end of each year. Based
on investor’s estimate of the dividend stream
and riskiness of that stream.