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In equation 7513 we can see that p0 will figure 74

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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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