This is based on stock markets being competitive and having n many profit-seekins investors. The following example illustrates the basic idea Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows 125 140 The opportunity cost of capital is 10 percent Discounted cash flow 2.29 1.11.12 What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term s of today's dollars of 0. 29. To see this another way Debt to buy share 2.00 2x1.1=2.2 0.95x1.1=1.045 (including interest) Less pay 1.25 End of period debt 0.95 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 55/1.12=0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.292 This is based on stock markets being competitive and having many profit-seeking investors. The following example illustrates the basic idea. Example Consider a firm which for simplicity only lasts for two periods and that has per share cash flows which are paid out to shareholders as follows: C1 C2 1.25 1.40 The opportunity cost of capital is 10 percent. What would happen if the stock was selling in the market at 2.00? How could investors make money? Suppose an investor borrowed 2.00 and bought one share. Since the discounted present value of the payments on the stock is 2.29 the investor will be able to pay back the loan and make a profit in term's of today's dollars of 0.29. To see this another way t= 0 1 2 Debt to buy share 2.00 2x1.1 = 2.2 0.95x1.1 = 1.045 (including interest) Less payment - 1.25 - 1.40 End of period debt = 0.95 = - 0.355 In other words the investor is left with 0.355 at date 2 which is equivalent to 0.355/1.12 = 0.29 at date 0. Everybody will therefore try to borrow and buy shares. The price will be bid up to 2.29. = 2.29 1.1 1.40 + 1.1 1.25 Discounted cash flow = 2