Wednesday, 9 May 2012
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.