336 PART 2 Important Financial Concepts
increase for any increase in D 1 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 technolog-
ical breakthrough that would revolutionize its industry. Current and prospec-
tive 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,D 1 , will remain at $1.50, the
expected rate of growth thereafter will increase from 7% to 9%. If we substi-
tuteD 1 $1.50,ks0.15, andg0.09 into Equation 7.5, the resulting value is
$25 [$1.50(0.150.09)]. The increased value therefore resulted from the
higher expected future dividends reflected in the increase in the growth rate.Changes in Risk
Althoughksis 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:ksRF[b (kmRF)] (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 Equa-
tion 7.5, we can see that with everything else constant, an increase in the required
return, ks, will reduce share value, P 0. 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 con-
tributes 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 cap-
ital asset pricing model, Equation 7.9, we get a required return, ks, of 15%:ks9%[1.50 (13%9%)] 1
5
%With this return, the value of the firm was calculated in the example above to be
$18.75.
Now imagine that the financial manager makes a decision that, without
changing expected dividends, causes the firm’s beta to increase to 1.75. Assuming
that RFand kmremain at 9% and 13%, respectively, the required return will
increase to 16% (9%[1.75 (13%9%)]) to compensate stockholders for the
increased risk. Substituting D 1 $1.50, ks0.16, and g0.07 into the valuation
equation, Equation 7.5, results in a share value of $16.67 [$1.50(0.16
0.07)]. As expected, raising the required return, without any corresponding
increase in expected return, causes the firm’s stock value to decline. Clearly, the
financial manager’s action was not in the owners’ best interest.