An Introduction to Finance and the Dividend Growth Model Cameron School of BusinessUNIVERSITY OF NORTH CAROLINA WILMINGTON Edward Graham Professor of Finance Department of Economics and Finance
Continuing your Introduction to Finance Recalling the Broad Introduction to Finance I. The Three Primary Duties of the Financial Manager II. Stock Valuation Primer: The Dividend Growth Model
An Introduction to Finance • What is finance? • Finance is the study of the art and the science of money • management; it is based on the Latin root finis, • meaning the end.In managing ours or our firm’s money, • we consider historical outcomes or “endings,” • and we propose future results as a function of decisions • made today. Those outcomes or results are • typically portrayed using financial statements.
The Three Primary Duties of the • Financial Manager • Whether managing monies for the home, or for the firm, our • duties are met with decisions framed by the same general • principles. These principles instruct us in making three main • types of decisions as we perform those three primary duties: • The capital budgeting decision • The capital structure decision • The working capital decision
The Capital Budgeting Decision • With the capital budgeting decision, the financial manager • decides where best to deploy monies long-term. The • purchase of a new delivery truck or a new warehouse • is a capital budgeting decision; the payment of a utility • bill is not. • With the making of this decision, we consider three features • of the cash flows deriving from the decision: • The size of the cash flows • The timing of the cash flows • The risk of the cash flows • We review a couple examples of capital budgeting decisions.
The Capital Structure Decision • With the capital structure decision, the financial manager decides • from where best to acquire monies long-term. The purchase of that • new delivery truck with cash or with a loan from GMAC or Ford • Motor Credit is a capital structure decision; the use of long-term • borrowing to fund a franchise purchase is another. • Perhaps most importantly, the decision to fund a firm’s growth with • equity - such as with funds invested by the firm’s founders, angel • investors, venture capitalists or public stock offerings – or debt, is • a critical capital structure choice. Two features of this choice bear • mentioning: • The risk of the debt • The loss of control and reduced potential cash flows to the • founders with an equity or stock sale • We expand our review with a few capital structure decisions.
The Working Capital Decision With the working capital decision, current assets and current liabilities become the focus of the financial manager. Such items as cash balances, accounts receivable, inventory levels and short-term accruals (such as prepaid rent or utilities) are included among the short-term assets that comprise one component of working capital. Also with the working capital decision, we concern ourselves with short-term obligations such as accounts payable to vendors, and other debt that is expected to be paid off within one year. Net working capital is a meaningful outcome of the working capital decision-making matrix. Net working capital is merely the difference between current assets and current liabilities.
II. Stock Valuation Primer: Dividend Growth Model Recall the primary goal of making decisions towards the maximization of shareholder wealth. How do we know when we are doing that? We must first understand stock value. Here, we are introduced to the “idea” of stock valuation, understanding that for the “pro’s,” this is a life-long learning experience. • Table 7.1 guides us. • Section 7.2 provides some general definitions and features of the domestic stock markets.
The Dividend Growth Model (DGM) in Section 7.1 A great summary of the features of the DGM is given in Table 7.1 on page 203. As well, assigned homework problems for all of chapter 7, and the practice questions for chapter 7 from the web file “Chapter 6 – 8 Practice Questions,” are supportive. • First, the DGM in the simplest case: Suppose a stock has a single cash flow (cf) in one year of $20.00. What is the value of that stock? Well, our chapter 4 stuff on valuing single cf’s tells us: Stock Value = $20/(1 + r)^t, where r = 15% and t = 1
The Dividend Growth Model (DGM) in Section 7.1 Stock Value = $20/(1 + r)^t, where r = 15% and t = 1 Kind of makes sense, if our required return or “r” is 15%, and the cf in one year makes t equal to 1, we have: Stock Value (Po) = 20/1.15 = 17.39. Where the “gain” from buying the stock now for $17.39 to its value in a year of $20 (a gain of $2.61) gives us our 15% return of 2.61/17.39. We get a 15% return by selling our stock in a year for $20, having bought it for $17.39. But, what if our time value of money (or required return, in this case) is greater than 15%? Well, recalling V=I/R, our classic valuation function, with a bigger R comes a smaller V. Examples?
The Dividend Growth Model (DGM) in Section 7.1 • Second, the DGM with constant and perpetual cf’s: Assume now that our $20 “dividend” occurs every year – our stock “pays” a $20 annual dividend. What is the stock value now? Recalling work from chapter 5, for valuing constant cash flows: Value = cf/r, or as in Table 7.1, Po= D/R, where the dividend is D or $20, and R is r - our discount rate of 15%, and Po = 20/.15 = $133.33. Our 15% annual return is provided where R = D/Po or 15% = 20/133.33.
The Dividend Growth Model (DGM) in Section 7.1 • Third, and as in part III of Table 7.1, what of the value of our stock if its dividend or cf is growing at 10% per year? Po = D1/(R – g), where D1 is the dividend one period hence, R is our 15% required return as before, and g is 10%, our assumed annual dividend growth rate in this example. We find that D1 = D0(1 + g) = 20(1.1) = 22. R – g = .05 … • So, Po = 22/.05 = 440. And, P1 = D2/.05 = 22(1.1)/.05 = 24.2/.05 = 484 • Our overall return becomes R = D1/Po + g. (See the algebra?) R = a dividend yield plus a capital gains yield.
The Dividend Growth Model (DGM) in Section 7.1 Our R, then, based on the algebra, is comprised of a dividend yield and a capital gains yield: Requiring a 15% return, we get it in two ways, from dividends and from capital gains. Our dividend is going to be $22 in this last example (D1), and our capital gain is going to be P1 - Po, or $484 minus $440, or $44. Our total return becomes the sum of these, or $22 plus $44 or $66, which is exactly 15% of our original investment of $440. (D1 + [P1 – Po])/Po is (22 + 44)/440 or 66/440 or 15%. Pretty straightforward once you think about it! Use Table 7.1 to support your introduction to the DGM.
The Dividend Growth Model (DGM) and Section 7.2 • Finally, remember that with the DGM we have been valuing common stock, as described and discussed in your text in Section 7.2. • Common stock has certain ownership rights to the future cash flows of a publicly traded corporation, and these rights are securitized and traded on the Nasdaq or the NYSE. And, it is the value of those “traded rights” or shares of common stock that we have been trying to estimate. • Bonds in chapter 6 were “easy.” The size and timing of the cash flows with them, and the market’s “required return” (or yield to maturity) were all published as the bonds were traded. But, with stocks, the size, timing and duration of the cash flows are uncertain, and the market’s required return is unknown, as well. So, we estimate the required return, and the cash flows, and START to get a sense of the value with the DGM. • It is just a START, but we must start somewhere!! Good luck!