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Unformatted text preview: divisions of a larger public company. The model finds the value of the entire company by discounting the firm’s expected free cash flow at its weighted average cost of capital. The common stock value is found by subtracting the market values of the firm’s debt and preferred stock from the value of the entire company. The two equations involved in this model are summarized in Table 7.6. Explain the relationships among financial decisions, return, risk, and the firm’s value. In a stable economy, any action of the financial manager that increases the level of expected return without changing risk should increase share value, and any action that reduces the level of expected return without changing risk should reduce share value. Similarly, any action that increases risk (required return) will reduce share value, and any action that reduces risk will increase share value. Because most financial decisions affect both return and risk, an assessment of their combined effect on stock value must be part of the financial decision-making process. LG5 SELF-TEST PROBLEMS LG6 (Solutions in Appendix B) LG4 ST 7–1 Common stock valuation Perry Motors’ common stock currently pays an annual dividend of $1.80 per share. The required return on the common stock is 12%. Estimate the value of the common stock under each of the following assumptions about the dividend. a. Dividends are expected to grow at an annual rate of 0% to infinity. b. Dividends are expected to grow at a constant annual rate of 5% to infinity. c. Dividends are expected to grow at an annual rate of 5% for each of the next 3 years, followed by a constant annual growth rate of 4% in years 4 to infinity. LG5 ST 7–2 Free cash flow valuation Erwin Footwear wishes to assess the value of its Active Shoe Division. This division has debt with a market value of $12,500,000 and no preferred stock. Its weighted average cost of capital is 10%. The Active 340 PART 2 Important Financial Concepts TABLE 7.6 Summary of Key Valuation Definitions and Formulas for Common Stock Definitions of variables Dt FCFt g per-share dividend expected at the end of year t free cash flow expected at the end of year t constant rate of growth in dividends g1 initial dividend growth rate (in variable-growth model) g2 subsequent dividend growth rate (in variable-growth model) ka weighted average cost of capital ks required return on common stock N last year of initial growth period (in variable-growth model) P0 value of common stock VC value of the entire company VD market value of all the firm’s debt VP market value of preferred stock VS value of common stock Valuation formulas Basic stock value: P0 D1 ks)1 D2 ks)2 ... D∞ ks)∞ [Eq. 7.2] D1 (also used to value preferred stock) ks [Eq. 7.3] D1 ks g [Eq. 7.5] (1 (1 (1 Common stock value: Zero-growth: P0 Constant-growth: P0 Variable-growth: N P0 t1 D0 (1 g1)t (1 ks)t (1 1 ks)N DN 1 ks g2 [Eq. 7.6] FCF∞ [Eq. 7.7] FCF value of entire company: VC FCF1 (1 ka)1 FCF2 (1 ka)2 ... VC VP (1 ka)∞ FCF common stock value: VS...
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This document was uploaded on 01/19/2014.

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