If the expected return were above the 2 a great deal

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Unformatted text preview: pected return is less than ˆ the required return (k k), investors sell the asset, because they do not expect it to earn a return commensurate with its risk. Such action drives the asset’s price down, which (assuming no change in expected benefits) causes its expected return to rise to the level of its required return. If the expected return were above the 2. A great deal of theoretical and empirical research has been performed in the area of market efficiency. For purposes of this discussion, generally accepted beliefs about market efficiency are described, rather than the technical aspects of the various forms of market efficiency and their theoretical implications. For a good discussion of the theory and evidence relative to market efficiency, see William L. Megginson, Corporate Finance Theory (Boston, MA: Addison Wesley, 1997), Chapter 3. CHAPTER 7 Stock Valuation 323 ˆ required return (k k), investors would buy the asset, driving its price up and its expected return down to the point where it equals the required return. EXAMPLE The common stock of Alton Industries (AI) is currently selling for $50 per share, and market participants expect it to generate benefits of $6.50 per share during each coming period. In addition, the risk-free rate, RF, is currently 7%; the market return, km, is 12%; and the stock’s beta, bAI, is 1.20. When these values are ˆ substituted into Equation 7.1, the firm’s current expected return, k0, is $6.50 $50.00 ˆ k0 13% When the appropriate values are substituted into the CAPM (Equation 5.8), the current required return, k0, is k0 7% [1.20 (12% 7%)] 7% 6% 13% ˆ Because k0 k0, the market is currently in equilibrium, and the stock is fairly priced at $50 per share. Assume that a press release announces that a major product liability suit has been filed against Alton Industries. As a result, investors immediately adjust their risk assessment upward, raising the firm’s beta from 1.20 to 1.40. The new required return, k1, becomes k1 7% [1.40 (12% 7%)] 7% 7% 14% Because the expected return of 13% is now below the required return of 14%, many investors sell the stock—driving its price down to about $46.43—the price ˆ that will result in a 14% expected return, k1. ˆ k1 $6.50 $46.43 14% The new price of $46.43 brings the market back into equilibrium, because the expected return now equals the required return. The Efficient-Market Hypothesis efficient-market hypothesis Theory describing the behavior of an assumed “perfect” market in which (1) securities are typically in equilibrium, (2) security prices fully reflect all public information available and react swiftly to new information, and, (3) because stocks are fairly priced, investors need not waste time looking for mispriced securities. As noted in Chapter 1, active markets such as the New York Stock Exchange are efficient—they are made up of many rational investors who react quickly and objectively to new information. The efficient-market hypothesis, which is the basic theory describing the behavior of such a “perfect” market, specificall...
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