Firms obtain 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. Unlike interest payments on debt which are tax deductible, dividends must 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 such as the election of the Board of Directors. Preferred stock, on the other hand, is a hybrid form of financing, sharing some features with debt and some with common equity. For example, preferred dividends like interest payments on debt are generally 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 debtholders and preferred stockholders have been paid. Moreover, the cash flow that remains after interest and preferred dividends have been paid belongs to the common stockholders.

The priority of the claims against the assets of the firm belonging to debtholders, 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 means that the debtholders must receive their scheduled interest and principal payments before any dividends can be paid to the equity holders. If these claims are not paid, the debtholders can force the firm into bankruptcy. The preferred stockholders have the next claim. They must be paid the full amount of their scheduled dividends before any dividends may be distributed to the common stockholders.

The value of these securities, as with other assets, is based upon the discounted value of their expected future cash flows. In this section, 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 which mirrors the long-term growth rate of the economy. The second approach is a more general approach which can be applied to value stocks whose growth is not constant in the near term.

Concepts

Tools and Problems

2002 — 2010 by Mark A. Lane, Ph.D.