Firms
receive their long-term sources of
equity financing by issuing common and preferred stock. The payments of the
firm to the holders of these securities are in the form of dividends.
In contrast to interest payments on debt
that are tax deductible, dividends
should be paid out of after-tax income.
The common stockholders are the owners of the firm. They have the right to
vote on important matters to the firm
like the
election of the Board of Directors. Preferred stock, on the
opposite hand, is a hybrid form of financing,
sharing some features with debt and some with common equity. For
instance, preferred dividends like interest payments
on debt are
usually fixed. In addition, the
claims against the assets of the firm of the preferred stockholders, like those
of the debtholders, are also fixed.
The common stockholders have a residual claim against the assets and cash
flows of the firm. That is, the common stockholders have a claim against
whatever assets remain after the debt-holders and preferred stockholders
are paid. Moreover, the cash flow that remains after
interest and preferred dividends
are paid
belongs to the common stockholders.
The priority of the claims against the assets of the firm belonging to debt-holders, preferred stockholders, and common stockholders differ. The owners
of the firm's debt securities have the first claim against the assets of the
firm. This
implies that the debt-holders
should get their scheduled interest and principal
payments before any dividends
may be paid to
the equity holders. If these claims
aren't
paid, the debt-holders can force the firm into bankruptcy. The preferred
stockholders have the next claim. They
have to
be paid the
total amount of their scheduled
dividends before any dividends may be distributed to the common stockholders.
The value of these securities,
like other
assets,
relies upon the discounted value of
their expected future cash flows. Time Value of Money principles are applied to
value common and preferred stock. Two approaches are presented for the
valuation of common stock. The first approach illustrates the valuation of a
constant growth stock,
i.e., a stock whose dividends are growing at a
rate
that mirrors the long-term growth rate of
the economy. The second approach is a more general approach which
may be applied to value stocks whose growth
isn't constant in the near term.
Posted on Wednesday, 9th of May, 2012.
