Principles of Managerial Finance

CHAPTER 7 Stock Valuation 335

Decision

Action by

Financial

Manager

Effect on

Stock Value

P 0 =

ks – g

Effect on

1. Expected Return
   Measured by Expected
   Dividends, D 1 , D 2 , ..., Dn,
   and Expected Dividend
   Growth, g.


2. Risk Measured by the
   Required Return, ks.

D 1

FIGURE 7.4

Decision Making
and Stock Value
Financial decisions, return,
risk, and stock value

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.

LG6

Review Questions

7–13 Describe the events that occur in an efficient marketin response to new

information that causes the expected return to exceed the required return.

What happens to the market value?

7–14 What does the efficient-market hypothesissay about (a) securities prices,

(b) their reaction to new information, and (c) investor opportunities to

profit?

7–15 Describe, compare, and contrast the following common stock dividend

valuation models: (a) zero-growth, (b) constant-growth, and (c) variable-

growth.

7–16 Describe the free cash flow valuation modeland explain how it differs

from the dividend valuation models. What is the appeal of this model?

7–17 Explain each of the three other approaches to common stock valuation:

(a) book value, (b) liquidation value, and (c) price/earnings (P/E) multi-

ples. Which of these is considered the best?

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 7.4 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 expecta-

tions should increase the firm’s value. In Equation 7.5,^13 we can see that P 0 will