CHAPTER 7 (5).pptx

Principles of Managerial Finance Sixteenth Edition, Global Edition Chapter 7 Stock Valuation Copyright © 2022 Pearson Education, Ltd. Learning Goals LG 1 Differentiate between debt...

Principles of Managerial Finance Sixteenth Edition, Global Edition Chapter 7 Stock Valuation Copyright © 2022 Pearson Education, Ltd. Learning Goals LG 1 Differentiate between debt and equity. LG 2 Discuss the features of both common and preferred stock. LG 3 Apply the basic valuation model to stocks, and describe the relevant cash flows and the impact of required return. LG 4 Explain the relationships among financial decisions, return, risk, and the firm’s value. Copyright © 2022 Pearson Education, Ltd. 7.1 Differences Between Debt and Equity Debt – Includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments Equity – Consists of funds provided by the firm’s owners (investors or stockholders) that are repaid subject to the firm’s performance Copyright © 2022 Pearson Education, Ltd. 7.1 Differences Between Debt and Equity Voice in Management – Unlike creditors, stockholders own the firm, and they generally have voting rights that permit them to select the firm’s directors and vote on special issues – Debtholders do not receive voting privileges but instead rely on the firm’s contractual obligations to be their voice Copyright © 2022 Pearson Education, Ltd. 7.1 Differences Between Debt and Equity (3 of 5) Claims on Income and Assets – Stockholders’ claims on income and assets are secondary to the claims of creditors – Because stockholders are the last to receive any distribution of assets and because they have a lower priority claim on the firm’s income, their investment is relatively risky, and they expect higher returns as compensation – Therefore, the cost of equity financing is higher than the cost of debt financing for the firm Copyright © 2022 Pearson Education, Ltd. 7.1 Differences Between Debt and Equity (4 of 5) Maturity – Unlike debt, equity financing is permanent  It does not “mature” or require repayment at any time  Stockholders recognize they can sell their shares at any time in the liquid, secondary market, but they cannot know what the share price will be when they are ready to sell Copyright © 2022 Pearson Education, Ltd. 7.1 Differences Between Debt and Equity (5 of 5) Tax Treatment – Interest payments to debtholders are treated as tax- deductible expenses by the issuing firm. – Dividend payments to stockholders, on the other hand, are not deductible and do not reduce taxes at all – The tax deductibility of interest lower’s the corporation’s cost of debt financing—yet another reason the cost of debt financing is lower than that of equity financing Copyright © 2022 Pearson Education, Ltd. Table 7.1 Key Differences Between Debt and Equity a Debtholders do not have voting rights, but instead they rely on the firm’s contractual obligations to them to be their voice. Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Ownership  Privately Owned (Stock) – The common stock of a firm is owned by private investors; this stock is not publicly traded  Publicly Owned (Stock) – The common stock of a firm is owned by public investors; this stock is publicly traded  Closely Owned (Stock) – The common stock of a firm is owned by an individual or a small group of investors (such as a family); they are usually privately owned companies Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Par Value  Par Value of Common Stock – An arbitrary value that is established for legal purposes in the firm’s corporate charter and that can be used to find the total number of shares outstanding by dividing it into the book value of common stock – Preemptive Rights  Allows common stockholders to maintain their proportionate ownership in the corporation when new shares are issued, thus protecting them from dilution of ownership Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Preemptive Rights  Dilution of Ownership – A reduction in each previous shareholder’s fractional ownership resulting from the sale of new common shares  Dilution of Earnings – A reduction in each previous shareholder’s fractional claim on the firm’s earnings resulting from the sale of new common shares  Rights – Financial instruments that allow stockholders to purchase additional shares at a price below the market price, in direct proportion to their fractional ownership Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Authorized, Outstanding, and Issued Shares  Authorized Shares – Shares of common stock that a firm’s corporate charter allows it to issue  Outstanding Shares – Issued shares of common stock held by investors, including both private and public investors  Treasury Stock – Issued shares of common stock held by the firm – Often these shares have been repurchased by the firm Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Authorized, Outstanding, and Issued Shares  Issued Shares – Shares of common stock that have been put into circulation; the sum of outstanding shares and treasury stock Copyright © 2022 Pearson Education, Ltd. Example 7.2 An abbreviated equity section of the Walgreens balance sheet at the end of a recent fiscal year looked like this: Stockholders’ Equity ($ millions) Common stock—$0.01 par value: Authorized 3.2 billion shares; issued 1.2 billion shares $ 12 Paid-in capital in excess of par 10,639 Retained earnings 35,815 $46,466 Less: Cost of treasury stock (0.8 billion shares) -19,057 Total stockholders’ equity $27,409 Copyright © 2022 Pearson Education, Ltd. Example 7.2 How many shares of additional common stock can Walgreens sell without gaining approval from its shareholders? The firm has 3.2 billion authorized shares, 1.2 billion issued shares, and 0.8 billion shares of treasury stock. Thus, 0.4 billion shares are outstanding (1.2 billion issued shares minus 0.8 billion shares of treasury stock), and Walgreens can issue 2.8 billion additional shares (3.2 billion authorized shares minus 0.4 billion outstanding shares) without seeking shareholder approval. This total includes the treasury shares currently held, which the firm can reissue to the public without obtaining shareholder approval. Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Voting Rights  Proxy voting – Voting by a party designated by a shareholder who wants to retain ownership of their shares but is willing to pass the voting right to someone else  Proxy Statement – A document outlining issues coming to a vote at a shareholders’ meeting  Proxy Battle – The attempt by a nonmanagement group to gain control of the management, or to influence management, by soliciting a sufficient number of proxy votes Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Voting Rights  Supervoting Shares – Stock that carries with it multiple votes per share rather than the single vote per share typically given on regular shares of common stock  Nonvoting Common Stock – Common stock that carries no voting rights; issued when the firm wishes to raise capital through the sale of common stock but does not want to give up its voting control Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Common Stock – Dividends  The payment of dividends to the firm’s shareholders is at the discretion of the company’s board of directors  Most corporations that pay dividends distribute them quarterly  Once companies start paying dividends, they are usually reluctant to cut them, much less to stop paying them at all  Cash dividends are the most common Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Preferred Stock – Most corporations do not issue preferred stock, but preferred shares are common in some heavily regulated industries – Preferred stock gives its holders privileges that make them senior to common stockholders – Preferred stockholders receive a fixed periodic dividend, stated either as a percentage or as a dollar amount Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Preferred Stock – Par-Value Preferred Stock  Preferred stock with a stated face value that is used with the specified dividend percentage to determine the annual dollar dividend – No-Par Preferred Stock  Preferred stock with no stated face value but with a stated annual dollar dividend Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Preferred Stock – Rights of Preferred Stockholders  Preferred stock is often considered quasi-debt – much like interest on debt, it specifies a fixed periodic payment (dividend) – unlike debt, preferred stock has no maturity date and preferred stockholders cannot force a firm into bankruptcy if the firm misses dividend payments Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Preferred Stock – Rights of Preferred Stockholders  Preferred shares have a higher priority claim on the firm’s current income than do common stockholders  Preferred stockholders are given preference over common stockholders in the liquidation of assets in a legally bankrupt firm, although they must “stand in line” behind creditors  Preferred stockholders do not normally have voting rights, although they sometimes can elect one member of the board of directors Copyright © 2022 Pearson Education, Ltd. 7.2 Common and Preferred Stock Preferred Stock – Features of Preferred Stock  Cumulative (Preferred Stock) – Preferred stock for which all passed (unpaid) dividends in arrears, along with the current dividend, must be paid before dividends can be paid to common stockholders  Noncumulative (Preferred Stock) – Preferred stock for which passed (unpaid) dividends do not accumulate Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation The value of a share of common stock equals the present value of its expected cash flows. Common Stock Dividend Valuation Model D1 D2 D P0   ...  (7.1) 1 (1  r ) (1  r ) 2 (1  r )  – P0 = Value today of common stock – Dt = Dividend expected at the end of year t – r = Required return on common stock Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Zero-Growth Dividend Model  An approach to dividend valuation that assumes a constant, nongrowing dividend stream D1 = D2 = … = D∞  1 1 D1 P0 D1  t D1   (7.2) t 1 (1  r ) r r Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.3 From 2015 to 2020, Rocky Mountain Chocolate Factory (RMCF) paid a steady dividend of $0.48 per year. They paid that dividend in quarterly installments, but for simplicity, let’s value RMCF stock assuming that investors get their dividend checks at the end of each year. What discount rate should we use? Later in this text, we will explore that question in more depth. For now, let’s say that chocolate is one of life’s necessities, so people buy it whether the economy is booming or shrinking. This makes RMCF a bit less risky than an average company. If we think that over the long run the required return on a typical stock is 10%, perhaps for RMCF 8% is a reasonable discount rate. Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.3 Applying those assumptions to Equation 7.2 we estimate that RMCF’s stock price should be $0.48 P0  $6 0.08 In fact, in the first few months of 2020, the actual stock price fluctuated in a range from $3.77 to $9.25, but the average price over that period was $6.90. The constant- growth model’s prediction is not far off the actual market price, though the price fluctuations suggest that investors’ opinions about the model’s assumptions (i.e., expected dividends and the 8% required return) were shifting over time. Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Constant-Growth Dividend Model  A dividend valuation approach that assumes dividends will grow at a constant rate, but a rate less than the required return D0 (1  g )1 D0 (1  g ) 2 D0 (1  g )  P0   ...  (7.3) (1  r )1 (1  r ) 2 (1  r )  – Gordon Growth Dividend Model  A common name for the constant-growth dividend model that is widely cited in dividend valuation D1 P0  (7.4) r g Copyright © 2022 Pearson Education, Ltd. Example 7.4 The consumer products giant, Procter & Gamble (P&G), has paid dividends to stockholders for more than 100 years. To estimate the long-run dividend growth rate, we will calculate the growth in P&G’s annual dividend from 1999 ($1.21 per share) to 2019 ($2.955 per share). We assume that the historical average annual growth rate of dividends is a reasonable estimate of the future constant annual dividend growth rate, g. Copyright © 2022 Pearson Education, Ltd. Example 7.4 To find the historical average annual growth rate of dividends, we must solve the following for g: 20 D2019 D1999  1  g  D2019 20  1  g  D1999 $2.955 20  1  g  $1.21 1  $2.955  20    1  g   $1.21  0.046 4.6%  g Copyright © 2022 Pearson Education, Ltd. Example 7.4 We estimate that P&G’s dividend in 2020, D1, will equal $3.09 (about 4.6% more than the 2019 dividend). P&G is in a relatively mature, steady consumer products business, so we assume a discount rate, r, of 7%. By substituting these values into Equation 7.4, we estimate the value of the stock to be $3.09 P0  $128.75 0.070  0.046 Given the estimated values of D1, r, and g, P&G’s stock value is $128.75 per share. Again we can compare this estimate to P&G’s actual market price, which from January through April 2020 averaged about $126. Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Variable-Growth Dividend Model  A dividend valuation approach that allows for a change in the dividend growth rate  Step 1 – Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years one through n Dt D0 (1  g1 )t Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Variable-Growth Dividend Model  Step 2 – Find the present value of the dividends expected during the initial growth period n Dt D1 D2 Dn  t   2 L  n t 1 1 r    1 r  1  r 1 r  Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Variable-Growth Dividend Model  Step 3 – Find the value of the stock at the end of the initial growth period, by applying the constant-growth model (Equation 7.4) to the dividends expected from year n + 1 to infinity Dn 1 1  r  g2  1  r  n Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Common Stock Dividend Valuation Model – Variable-Growth Dividend Model  Step 4 – Add the present value components found in Steps 2 and 3 to find the value of the stock, P0, given in Equation 7.5: n D0 (1  g1 )t  1 Dn 1  P0  t  n   (7.5) (1  r ) (1  r ) r  g       2    t 1      Present value of dividends Present value of price of stock during initial growth period at end of initial growth period Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 One of the world’s leading semiconductor companies, Broadcom, enjoyed a long history of spectacular growth. In its first 12 years as a public company, Broadcom increased total revenues by 34% per year on average. With those growth opportunities, the company paid no dividends and reinvested its earnings instead. But as the semiconductor industry matured, growth opportunities became scarce. The company started paying dividends in 2010 and increased them rapidly over the next decade. In 2020, Broadcom paid $13 per share in dividends, an increase of 23% from the prior year. Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 No firm can sustain double-digit growth forever. In the very long run, the limit on growth is the growth rate of the overall economy. We will estimate the value of Broadcom stock using a 10% required rate of return and assuming that dividends will grow for the next three years at 20%. After that we’ll assume that dividends continue to grow indefinitely, but at a much slower 3% pace. Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 Step 1 We begin by estimating dividends for the next three years (2021, 2022, and 2023) based on a 20% increase each year from the $13 dividend in 2020. D2021 = $13 × (1 + 0.20) = $15.60 D2022 = $13 × (1 + 0.20)2 = $18.72 D2023 = $13 × (1 + 0.20)3 = $22.46 Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 Step 2 The sum of the present values in 2020 of the next three dividends ($15.60, $18.72, $22.46) is now calculated using a 10% discount rate. PV2020 = $15.60 ÷ (1 + 0.10) + $18.72 ÷ (1 + 0.10)2 + $22.46 ÷ (1 + 0.10)3 = $14.18 + $15.47 + $16.88 = $46.53 Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 Step 3 To find the value of the stock at the end of the initial growth period n = 2023, first calculate the dividend in 2024, Dn+1 = D2024: D2024 = D2023 × 1.03 = $22.46 × 1.03 = $23.14 Based on D2024 = $23.14, a 10% required return, and a 3% dividend growth rate, the value in 2023 of all dividends paid in 2024 and beyond, or equivalently the price of the stock in 2023, is D2024 $23.14 P2023   $330.57 r  g 2 0.10  0.03 Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 Step 3 Finally, convert the $330.57 share value in 2023 into a present (2020) value by discounting it at 10% for three years as follows P2023 $330.57 3  3 $248.36 1 r   1.10  Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.5 Step 4 As specified in Equation 7.5, add the present value of the initial dividend stream (found in Step 2) to the present value of the stock at the end of the initial growth period (found in Step 3) to obtain the current value of Broadcom stock P0 = $46.53 + $248.36 = $294.89 Given our assumptions, the variable growth model estimates that in 2020 Broadcom stock is worth $294.89. In fact, in the first four months of 2020, Broadcom stock fluctuated in a range from $168 to $325, with an average price of $275. Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Free Cash Flow Stock Valuation Model – A model that determines the value of an entire company as the present value of its expected free cash flows discounted at the firm’s weighted average cost of capital, which is its expected average future cost of funds over the long run – Free cash flow is the cash flow available to investors— the providers of debt (creditors) and equity (owners)— after the firm meets all of its other obligations – Particularly useful when valuing firms that have no dividend history or are startups, or when valuing an operating unit or division of a larger public company Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Free Cash Flow Stock Valuation Model FCF1 FCF2 FCF VC   ...  (7.6) 1 (1  rWACC ) (1  rWACC ) 2 (1  rWACC ) – V C = Value of the entire company – F CF t = Free cash flow expected at the end of year t – r WAC C = The firm’s weighted average cost of capital Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Free Cash Flow Stock Valuation Model – Because the value of the entire company, V C, is the market value of the entire enterprise (i.e., of all assets), to find common stock value, V S, we must subtract the market value of all the firm’s debt, V D, and the market value of preferred stock, V P, from V C : V S = V C − V D − V P (7.7) Copyright © 2022 Pearson Education, Ltd. Example 7.6 On December 31, 2019, Ruth’s Hospitality Group, which operates the nationwide chain of Ruth’s Chris Steak House restaurants, reported free cash flow of $24.83 million. Over the previous three years, the company had been growing at a 7% clip, so we will assume that free cash flows will grow at that rate for five years before settling down to a long-run growth rate of 4%. Table 7.2 lists the expected end-of-year cash flows from 2020 to 2024 along with other information necessary to complete the valuation. We can now value the stock as of the start of 2020 in four steps. Copyright © 2022 Pearson Education, Ltd. Example 7.6 Step 1 First calculate the present value of each cash flow that Ruth’s produces in the years 2020 through 2024. The first several rows of Table 7.3 list those present values. For example, the $26.57 million free cash flow arriving at the end of 2020 is 7% more than the $24.83 million free cash flow the year before. Using a 10% discount rate, the present value of the 2020 free cash flow is $24.15. Copyright © 2022 Pearson Education, Ltd. Example 7.6 Step 2 Use the constant growth model to calculate the present value, as of 2024, of all cash flows that arrive in years 2025 and beyond. Because cash flows grow at a steady 4% rate over that time horizon, the free cash flow in 2025 is $36.22 (4% more than the 2024 cash flow of $34.83). Therefore, we can calculate the present value at the end of 2024 of all cash flows from 2025 and beyond as follows: PV2024 = FCF2025 ÷ (rWACC − g) =36.22 ÷ (0.10 − 0.04) = $603.67 $ Copyright © 2022 Pearson Education, Ltd. Example 7.6 Step 2 Finally, since we are valuing Ruth’s Hospitality Group as of the start of 2020, we need to discount the $603.67 million figure an additional five years to calculate its present value today (not in 2024). Table 7.3 shows that the present value is $374.72 million. Copyright © 2022 Pearson Education, Ltd. Example 7.6 Step 3 Add up the present values of the individual cash flows from 2020 to 2024 as well as the present value of cash flows that arrive in 2025 and beyond to get the total value, Vc, of Ruth’s Hospitality Group in 2020. Table 7.3 shows that the company’s total value is $489.07 million. Step 4 Calculate the value of the common stock using Equation 7.7. Substituting into Equation 7.7 the value of the entire company, V C, calculated in Step 3, and the market values of debt, V D, and preferred stock, V P, given in Table 7.2, yields the value of the common stock, V S: VS = $489.07 − $300 − $0 = $189.07 Copyright © 2022 Pearson Education, Ltd. Table 7.2 Ruth’s Hospitality Group Data for the Free Cash Flow Valuation Model Copyright © 2022 Pearson Education, Ltd. Table 7.3 Calculation of the Value of the Entire Company for Ruth’s Hospitality Group (in millions) Copyright © 2022 Pearson Education, Ltd. Example 7.6 (6 of 6) The estimated value of all Ruth’s common stock is $189.07 million. By dividing this total by the 28.4 million shares outstanding, we get a common stock value of $6.66 per share ($189.07 ÷ 28.4). Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Other Approaches to Common Stock Valuation – Book Value  Book Value per Share – The amount per common share remaining if all of the firm’s assets were sold for their exact book (accounting) value and if its liabilities (including preferred stock) were paid at book value Copyright © 2022 Pearson Education, Ltd. Example 7.7 Lamar Company’s balance sheet shows total assets of $6 million, total liabilities and preferred stock of $4.5 million, and 100,000 shares of common stock outstanding. Its book value per share is $6, 000, 000  $4,500, 000 $15 per share 100, 000 shares For many firms, the book value of assets is quite a bit less than the market value, so the book value per share is usually a conservative estimate of a stock’s value. However, if investors believe that the book value of a firm’s assets is overstated or the value of its liabilities is understated, the stock’s market value may fall short of its book value. Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Other Approaches to Common Stock Valuation – Liquidation Value  Liquidation Value per Share – The amount per common share remaining if all the firm’s assets were sold for their market value and liabilities (including preferred stock) were paid in full Lamar Company found on investigation that it could obtain $6.25 million if it sold its assets today. The firm’s liquidation value per share would therefore be $6, 250, 000  $4,500, 000 $17.50 per share 100, 000 shares Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Other Approaches to Common Stock Valuation – Price/Earnings (P/E) Multiples  Price/Earnings Multiple Approach – A popular technique used to estimate the firm’s share value – calculated by multiplying the firm’s earnings per share (EP S) by the average price/earnings (P/E) ratio for the industry  Two main versions – Forward P/E ratio divides the current stock price by a forecast of earnings over the next year – Trailing P/E ratio uses earnings over the previous year (trailing 12 months or TT M) in the denominator Copyright © 2022 Pearson Education, Ltd. 7.3 Common Stock Valuation Other Approaches to Common Stock Valuation – Price/Earnings (P/E) Multiples  The use of P/E multiples is especially helpful in valuing firms that are not publicly traded, but analysts use this approach for public companies too.  P/E multiple approach – is forward looking because stock prices are – Usually produces higher valuations than the book value or liquidation value approaches Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 7.9 Ann Perrier plans to use the price/earnings multiple approach to estimate the value of Lamar Company’s stock, which she currently holds in her retirement account. She estimates that Lamar Company will earn $1.90 per share next year (2020). This expectation is based on an analysis of the firm’s historical earnings trend and on expected economic and industry conditions. She finds the price/earnings (P/E) ratio for firms in the same industry to average at 20. Multiplying Lamar’s expected earnings per share (EP S) of $1.90 by this ratio gives her a value for the firm’s shares of $38, assuming that investors will continue to value the average firm at 20 times its earnings. Copyright © 2022 Pearson Education, Ltd. 7.4 Decision Making and Common Stock Value Changes in Expected Dividends – Any management action that would cause stockholders to raise their dividend expectations should increase the firm’s value (as long as stockholders perceive no increase in the risk of the future dividend stream) Copyright © 2022 Pearson Education, Ltd. Figure 7.2 Decision Making and Stock Value Copyright © 2022 Pearson Education, Ltd. Example 7.10 Using the constant-growth dividend model given earlier in Example 7.4, we estimate the Procter & Gamble’s stock was worth $128.75. Suppose that P&G announces a new product that has a clear competitive advantage in its market. Current and prospective stockholders might not adjust their required return of 7% because the company’s risk has not fundamentally changed, but they would expect future dividends to increase. Suppose, they expect that the dividend next year, D1, will remain at $3.09, but the expected growth rate thereafter will increase from 4.6% to 5.0%. If we substitute D1 = $3.09, r = 0.07, and g = 0.05 into Equation 7.4, the resulting share value is $154.50 [ $3.09 ÷ (0.07 - 0.05)]. The increased value, therefore, resulted from the higher expected future dividends reflected in the increase in growth rate. Copyright © 2022 Pearson Education, Ltd. 7.4 Decision Making and Common Stock Value Changes in Risk – Recall from Chapter 6: ∗ r = r⏟ RP +i + ⏟ risk −free risk rate , 𝑅𝐹 premium  r = nominal interest rate  r* = real interest rate  i = expected inflation rate  RP = risk premium above the risk-free rate Copyright © 2022 Pearson Education, Ltd. 7.4 Decision Making and Common Stock Value Changes in Risk – Any action taken by the financial manager that increases the risk shareholders must bear will also raise the risk premium required by shareholders and hence the required return – Any action by the financial manager that increases risk contributes to a reduction in value, and any action that decreases risk contributes to an increase in value Copyright © 2022 Pearson Education, Ltd. Example 7.11 Assume that Procter & Gamble’s 7% required return resulted from a risk-free rate of 1% and a risk premium of 6%. With this return, the firm’s share value was calculated in Example 7.4 to be $128.75. Now imagine the financial manager makes a decision that, without changing expected dividends, causes the firm’s risk premium to increase to 8%. Assuming that the risk-free rate remains at 1%, the new required return on Procter & Gamble stock will be 9% (1% + 8%), and substituting D1 = $3.09, r = 0.09, and g = 0.046 into the valuation equation (Equation 7.3) results in a new share value of $70.23 [ $3.09 ÷ (0.09 - 0.046)]. As expected, raising the required return, without any corresponding increase in expected dividends, makes the firm’s stock value decline. Clearly, the financial manager’s action was not in the owners’ best interest. Copyright © 2022 Pearson Education, Ltd. 7.4 Decision Making and Common Stock Value Combined Effect – A financial decision rarely affects dividends and risk independently; most decisions affect both factors, often in the same direction – As firms take on more risk, their shareholders expect to see higher dividends – The net effect on value depends on the relative size of the changes in these two variables Copyright © 2022 Pearson Education, Ltd. Example 7.12 If we assume that the two changes illustrated for Procter & Gamble in the preceding examples occur simultaneously, the key variable values would be D1 = $3.09, r = 0.09, and g = 0.05. Substituting into the valuation model, we obtain a share price of $77.25 [ $3.09 ÷ (0.09 - 0.05)]. The net result of the decision, which increased dividend growth (g, from 4.6% to 5%) as well as required return (r, from 7% to 9%), is negative. The share price decreased from $128.75 to $77.25. The decision does not appear to be in the best interest of the firm’s owners because it increases risk more than it increases dividend growth. Copyright © 2022 Pearson Education, Ltd. End of Lecture Copyright © 2022 Pearson Education, Ltd.