Chapter 7: Model of Stock Prices
Dividend valuation model:
Equity = contractual agreement representing claim to a share in the income and assets of a corporation
Common stock is the principal form of equity.
Bundle of rights:
1. Right to vote on issues that are important to the company
2. Right to be the residual claimant – funds that remain after holders of debt are paid
Cashflows come in the form of dividends
Assume the stock sells at price Pt today (period t). The stock pays dividend Dt+1 next period, Dt+2 after
two-periods, Dt+3 after three-periods, and so on, out to the infinite future.
Fact: the dividend payments of the stock can be exactly replicated by a portfolio of discount bonds
having different maturities.
Consider the following investment strategy. Purchase:
a one-period discount bond with face value D t+1,
a two-period discount bond with face value Dt+2,
a three-period bond with face value D t+3
.
.
Which pays:
Dt+1 after one-period
Dt+2 After two periods
Price of bonds:
To formalize our argument, let
i1t = yield to maturity on a one-period discount bond
i2t = annualized yield to maturity on a two-period discount bond
i3t = annualized yield to maturity on a three-period discount bond
Let Qt+1 be the price of the one-period bond, then
D t +1 Dt +2 Dt +3
Pt = + + …..+….
1+i 1 t (1+i 2t )2 (1+i 3 t )3
∞
Dt + j
Pt =∑ equation (2)
j =1 ( 1+i jt ) j
, Dividend valuation model
How would we know the value of future dividends?
How do we know what interest to use to discount the dividend payments?
1. Write down the key assumption built into the dividend valuation model.
Dividends are growing at a constant rate
2. Write down the compact equation that summarizes the dividend valuation
model? Explain in words.
It is equal to the PV of future dividend payments
3. What information do we need to apply the dividend valuation model in
practice?
Dividend, interest rate
4. What assumptions are combined to the dividend valuation model to obtain the
Gordon growth model?
Constant growth rate, next year’s dividend
5. Write down the equation that summarizes the Gordon growth model?
D1/(k-g)
6. Assuming the Fed will raise rates in May, what impact will this decision have
on stock prices? Explain.
Stock prices will go down because the investors now have higher risk
Chapter 9: Banks
A L
Reserves Checkable Deposits
Securities Non-transaction deposits
Loans Borrowings
Physical Capital [Capital is the PLUG]
B/S of Bank:
A L
Uses Sources
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller anyiamgeorge19. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $10.99. You're not tied to anything after your purchase.