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Unformatted text preview: tal asset pricing model, Equation 7.9, we get a required return, ks, of 15%:
ks 9% [1.50 (13% 9%)] 15% With this return, the value of the firm was calculated in the example above to be
Now imagine that the financial manager makes a decision that, without
changing expected dividends, causes the firm’s beta to increase to 1.75. Assuming
that RF and km remain at 9% and 13%, respectively, the required return will
increase to 16% (9% [1.75 (13% 9%)]) to compensate stockholders for the
increased risk. Substituting D1 $1.50, ks 0.16, and g 0.07 into the valuation
equation, Equation 7.5, results in a share value of $16.67 [$1.50 (0.16
0.07)]. As expected, raising the required return, without any corresponding
increase in expected return, causes the firm’s stock value to decline. Clearly, the
financial manager’s action was not in the owners’ best interest. CHAPTER 7 Stock Valuation 337 Combined Effect
A financial decision rarely affects return and risk independently; most decisions
affect both factors. In terms of the measures presented, with an increase in
risk (b), one would expect an increase in return (D1 or g, or both), assuming that
RF and km remain unchanged. The net effect on value depends on the size of the
changes in these variables.
EXAMPLE If we assume that the two changes illustrated for Lamar Company in the preceding examples occur simultaneously, key variable values would be D1 $1.50,
ks 0.16, and g 0.09. Substituting into the valuation model, we obtain a share
price of $21.43 [$1.50 (0.16 0.09)]. The net result of the decision, which
increased return (g, from 7% to 9%) as well as risk (b, from 1.50 to 1.75 and
therefore ks from 15% to 16%), is positive: The share price increased from
$18.75 to $21.43. The decision appears to be in the best interest of the firm’s
owners, because it increases their wealth. Review Questions
7–18 Explain the linkages among financial decisions, return, risk, and stock
7–19 Assuming that all other variables remain unchanged, what impact would
each of the following have on stock price? (a) The firm’s beta increases.
(b) The firm’s required return decreases. (c) The dividend expected next
year decreases. (d) The rate of growth in dividends is expected to
increase. S U M M A RY
FOCUS ON VALUE
The price of each share of a firm’s common stock is the value of each ownership interest.
Although common stockholders typically have voting rights, which indirectly give them a
say in management, their only significant right is their claim on the residual cash flows of
the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the
government (for taxes), and preferred stockholders. The value of the common stockholders’
claim is embodied in the cash flows they are entitled to receive from now to infinity. The
present value of those expected cash flows is the firm’s share value.
To determine this present value, cash flows are discounted at a rate that reflects the
riskiness of the forec...
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