Principles of Managerial Finance

CHAPTER 7 Stock Valuation 337

SUMMARY

FOCUS ON VALUE

The price of each share of a firm’s common stock is the value of each ownership interest.
Although common stockholders typically have voting rights, which indirectly give them a
say in management, their only significant right is their claim on the residual cash flows of
the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the
government (for taxes), and preferred stockholders. The value of the common stockholders’
claim is embodied in the cash flows they are entitled to receive from now to infinity. The
present value of those expected cash flows is the firm’s share value.
To determine this present value, cash flows are discounted at a rate that reflects the
riskiness of the forecast cash flows. Riskier cash flows are discounted at higher rates, result-
ing in lower present values than less risky expected cash flows, which are discounted at

Combined Effect

A financial decision rarely affects return and risk independently; most decisions

affect both factors. In terms of the measures presented, with an increase in

risk (b), one would expect an increase in return (D 1 org, or both), assuming that

RFandkmremain unchanged. The net effect on value depends on the size of the

changes in these variables.

EXAMPLE If we assume that the two changes illustrated for Lamar Company in the preced-

ing examples occur simultaneously, key variable values would be D 1 $1.50,

ks0.16, and g0.09. Substituting into the valuation model, we obtain a share

price of $21.43 [$1.50(0.160.09)]. The net result of the decision, which

increased return (g,from 7% to 9%) as well as risk (b,from 1.50 to 1.75 and

therefore ksfrom 15% to 16%), is positive: The share price increased from

$18.75 to $21.43. The decision appears to be in the best interest of the firm’s

owners, because it increases their wealth.

Review Questions

7–18 Explain the linkages among financial decisions, return, risk, and stock

value.

7–19 Assuming that all other variables remain unchanged, what impact would

eachof the following have on stock price?(a)The firm’s beta increases.

(b)The firm’s required return decreases.(c)The dividend expected next

year decreases. (d) The rate of growth in dividends is expected to

increase.