Module 11 Critical Thinking Assignment: Stock Valuation

Module 11 Critical Thinking Assignment stock Valuation And Weighted Ave

Cleaned assignment instructions:

Develop an academic paper answering the following questions related to stock valuation, preferred stock, dividend growth, rate of return, the Capital Asset Pricing Model (CAPM), and Weighted Average Cost of Capital (WACC). The paper should include introduction, detailed explanations of each concept, computations where applicable, and proper references. Use credible financial sources and scholarly references to support your analysis. Ensure proper APA referencing and in-text citations.

Paper For Above instruction

Stock valuation is a fundamental concept in finance that helps investors determine the intrinsic value of a company's shares. It involves analyzing dividends, growth rates, and required rates of return. Understanding preferred stock, dividend growth, and the cost of capital enables investors and managers to make informed financial decisions.

Preferred Stock Valuation and Market Price

Preferred stocks are hybrid securities that usually pay fixed dividends, making them similar to fixed-income instruments. The valuation of preferred stock generally follows the perpetuity formula, where the price is the dividend divided by the required rate of return. For instance, a preferred stock with a dividend of SAR 5,000 at 5% yields a dividend of SAR 250 annually. If the required rate of return is 7%, the market price can be calculated as SAR 250 / 0.07, resulting in approximately SAR 3,571.43. This indicates that if the dividend remains constant, the market price should align with this valuation (Ross, Westerfield, & Jaffe, 2021).

Market Value of Preferred Stock

In another scenario, PQR Corporation's preferred stock sells for SAR 2,000 per share with an annual dividend of SAR 160. To find whether this price is justified based on a 7% required return, the valuation formula is SAR 160 / 0.07, which equals approximately SAR 2,285.71. Since the current market price is SAR 2,000, it suggests the stock might be undervalued if the required return is indeed 7%, or alternatively, investors might be expecting growth or other benefits not captured in the dividend.

Stock Valuation Using Dividend Discount Model (DDM)

For companies like Dinosaur Corporation with expected perpetual growth, the Gordon Growth Model (a form of DDM) is employed. It calculates the stock's intrinsic value as the next year's dividend divided by the difference between the required rate of return and the growth rate. Given last year's dividend of SAR 360, a growth rate of 7%, and an expected return of 10%, the projected dividend for the next year is SAR 360 × (1 + 0.07) = SAR 385.20. The stock value is SAR 385.20 / (0.10 - 0.07) = SAR 12,840. Instead of using the last dividend, this valuation incorporates growth expectations, providing a more accurate picture of intrinsic value (Brealey, Myers, & Allen, 2020).

Growth Rate Calculation

The firm's growth rate (g) is a critical component, especially for retained earnings and valuation. It is calculated as ROE multiplied by the retention ratio. For example, if a firm has an ROE of 17% and retains 40% of earnings, the growth rate would be 0.17 × 0.40 = 6.8%. This reflects the company's capacity to grow through internally generated funds, assuming reinvestment and profit retention policies are optimal.

Expected Rate of Return on Stock

Using the dividend growth model, the expected rate of return (r) can be derived as (D1 / P0) + g, where D1 is the dividend in next period, and P0 is the current stock price. Given a dividend of SAR 400 last year, expected to grow at 5%, and current price SAR 10,000, D1 = SAR 400 × 1.05 = SAR 420. The expected return is SAR 420 / SAR 10,000 + 0.05 = 0.042 + 0.05 = 9.2%. This figure indicates the anticipated return an investor can expect based on current dividend policies and growth prospects (Damodaran, 2019).

Cost of Preferred Stock

For new preferred stock issuance, the rate of return (cost) considers flotation costs. Rodeo Corporation’s preferred stock offers an 8% dividend with a face value of SAR 5,000, and a market price of SAR 6,000. Flotation costs are 5% of the market price, which amounts to SAR 300. The net proceeds are SAR 5,700. The cost of preferred stock is SAR 400 / SAR 5,700 ≈ 7.02%. This reflects the effective cost for the company when raising capital via preferred stock, including issuance costs.

CAPM and Required Rate of Return

The Capital Asset Pricing Model (CAPM) forecasts the required return for a stock based on its beta, risk-free rate, and market return. For BB Corporation with a beta of 1.2, a risk-free rate of 5%, and an expected market return of 13%, the required return is: 5% + 1.2 × (13% − 5%) = 5% + 1.2 × 8% = 5% + 9.6% = 14.6%. This rate reflects the expected compensation for taking on systematic risk relative to the market (Fama & French, 2020).

Weighted Average Cost of Capital (WACC)

WACC combines the costs of debt, preferred stock, and equity, weighted by their proportional debt-equity structure. For Alexander Corporation, with debts of $400 million, preferred stock of $80 million, and common equity of $520 million, and a tax rate of 40%, the calculation involves various components:

  • After-tax cost of debt: 5% × (1 - 0.40) = 3%
  • Cost of preferred stock: 6% (given)
  • Cost of equity: 10% (given)

Weightings based on target structure: debt 40%, preferred 10%, equity 50%. The WACC formula yields:

WACC = (0.40 × 3%) + (0.10 × 6%) + (0.50 × 10%) = 1.2% + 0.6% + 5% = 6.8%. This rate is used for investment appraisal and corporate valuation, representing the minimum return required by investors for the firm’s projected risk profile (Brealey et al., 2020).

Conclusion

Understanding stock valuation, dividend growth models, CAPM, and WACC is essential for investment decision-making. Applying these concepts involves a combination of financial theory and practical computations, which guide shareholders and managers in optimizing capital structure, assessing investments, and estimating fair values. Accurate valuation and cost measurement ensure that firms can attract appropriate funding and create value for their shareholders.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Damodaran, A. (2019). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
  • Fama, E. F., & French, K. R. (2020). The cross-section of expected stock returns. Journal of Finance, 55(2), 427-465.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2021). Corporate Finance (12th ed.). McGraw-Hill Education.

Related Assignments