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**Unformatted text preview: **he firm to change. Figure 7.4 depicts the relationship
among financial decisions, return, risk, and stock value. Changes in Expected Return
Assuming that economic conditions remain stable, any management action that
would cause current and prospective stockholders to raise their dividend expectations should increase the firm’s value. In Equation 7.5,13 we can see that P0 will FIGURE 7.4
Decision Making
and Stock Value
Financial decisions, return,
risk, and stock value Decision
Action by
Financial
Manager Effect on
1. Expected Return
Measured by Expected
Dividends, D1, D2, …, Dn,
and Expected Dividend
Growth, g.
2. Risk Measured by the
Required Return, ks. Effect on
Stock Value
D1
P0 =
ks – g 13. To convey the interrelationship among financial decisions, return, risk, and stock value, the constant-growth
model is used. Other models—zero-growth, variable-growth, or free cash flow—could be used, but the simplicity of
exposition using the constant-growth model justifies its use here. 336 PART 2 Important Financial Concepts increase for any increase in D1 or g. Any action of the financial manager that will
increase the level of expected returns without changing risk (the required return)
should be undertaken, because it will positively affect owners’ wealth.
EXAMPLE Using the constant-growth model, we found Lamar Company to have a share
value of $18.75. On the following day, the firm announced a major technological breakthrough that would revolutionize its industry. Current and prospective stockholders would not be expected to adjust their required return of 15%,
but they would expect that future dividends will increase. Specifically, they
expect that although the dividend next year, D1, will remain at $1.50, the
expected rate of growth thereafter will increase from 7% to 9%. If we substitute D1 $1.50, ks 0.15, and g 0.09 into Equation 7.5, the resulting value is
$25 [$1.50 (0.15 0.09)]. The increased value therefore resulted from the
higher expected future dividends reflected in the increase in the growth rate. Changes in Risk
Although ks is defined as the required return, we know from Chapter 5 that it is
directly related to the nondiversifiable risk, which can be measured by beta. The
capital asset pricing model (CAPM) given in Equation 5.8 is restated here as
Equation 7.9:
ks RF [b (km RF)] (7.9) With the risk-free rate, RF, and the market return, km, held constant, the
required return, ks, depends directly on beta. Any action taken by the financial
manager that increases risk (beta) will also increase the required return. In Equation 7.5, we can see that with everything else constant, an increase in the required
return, ks, will reduce share value, P0. Likewise, a decrease in the required return
will increase share value. Thus any action of the financial manager that increases
risk contributes to a reduction in value, and any action that decreases risk contributes to an increase in value.
EXAMPLE Assume that Lamar Company’s 15% required return resulted from a risk-free
rate of 9%, a market return of 13%, and a beta of 1.50. Substituting into the capi...

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