7.4 Decision Making and Common Stock Value

LG 6 7.4 Decision Making and Common Stock Value

Valuation equations measure the stock value at a point in time based on expected return and risk. Any decisions of the financial manager that affect these variables can cause the value of the firm to change. Figure 7.3 depicts the relationship among financial decisions, return, risk, and stock value.

CHANGES IN EXPECTED DIVIDENDS Assuming that economic conditions remain stable, any management action that

would cause current and prospective stockholders to raise their dividend expecta- tions should increase the firm’s value. In Equation 7.4, we can see that P 0 will

g. Any action of the financial manager that will increase the level of expected dividends without changing risk (the required return) should be undertaken, because it will positively affect owners’ wealth.

increase for any increase in D 1 or

Example 7.9 3 Using the constant-growth model in an earlier example (on pages 281 and 282), 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 revolu- tionize its industry. Current and prospective stockholders would not be expected to adjust their required return of 15%, but they would expect that future divi- dends will increase. Specifically, they expect that although the dividend next year,

D 1 , will remain at $1.50, the expected rate of growth thereafter will increase from 7% to 9%. If we substitute D 1 = $1.50, r s = 0.15, and g = 0.09 into Equation 7.4, the resulting share value is $25 3$1.50 , (0.15 - 0.09)4 . The increased value therefore resulted from the higher expected future dividends reflected in the increase in the growth rate.

FIGURE 7.3

Effect on

Decision Making and Stock

1. Expected Return

Value

Effect on Financial decisions, return,

Decision

Measured by Expected

Stock Value risk, and stock value

Action by

Dividends, D 1 ,D 2 , …, D n ,

Financial

and Expected Dividend

Manager

Growth, g.

0 r s –g

2. Risk Measured by the Required Return, r s .

CHAPTER 7

Stock Valuation

CHANGES IN RISK Although the required return, r s , is the focus of Chapters 8 and 9, at this point we

can consider its fundamental components. Any measure of required return con- sists of two components, a risk-free rate and a risk premium. We expressed this relationship as Equation 6.1 in the previous chapter, which we repeat here in terms of r s :

r s = r* + IP + RP s

risk-free

risk rate, R F premium

In the next chapter you will learn that the real challenge in finding the required return is determining the appropriate risk premium. In Chapters 8 and 9 we will discuss how investors and managers can estimate the risk premium for any par- ticular asset. For now, recognize that r s represents the minimum return that the firm’s stock must provide to shareholders to compensate them for bearing the risk of holding the firm’s equity.

Any action taken by the financial manager that increases the risk share- holders must bear will also increase the risk premium required by shareholders, and hence the required return. Additionally, the required return can be affected by changes in the risk free rate—even if the risk premium remains constant. For example, if the risk-free rate increases due to a shift in government policy, then the required return goes up too. In Equation 7.1, we can see that an increase in

the required return, r s , will reduce share value, P 0 , and 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 7.10 3 Assume that Lamar Company’s 15% required return resulted from a risk-free rate of 9% and a risk premium of 6%. With this return, the firm’s share value

was calculated in an earlier example (on pages 280 and 281) to be $18.75. Now imagine that the financial manager makes a decision that, without changing expected dividends, causes the firm’s risk premium to increase to 7%. Assuming that the risk-free rate remains at 9%, the new required return on

Lamar stock will be 16% (9% + 7%), substituting D 1 = $1.50, r s = 0.16, and

g = 0.07 into the valuation equation (Equation 7.3), results in a new share value of $16.67 3$1.50 , (0.16 - 0.07)4 . As expected, raising the required return, without any corresponding increase in expected dividends, causes the firm’s stock value to decline. Clearly, the financial manager’s action was not in the owners’ best interest.