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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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