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You recently learned in chapter 7 how to value stocks using the constant dividend growth model...

You recently learned in chapter 7 how to value stocks using the constant dividend growth model and free cash flow valuation model. These models show that current stock prices depend heavily on two value drivers, namely, the future growth rate of dividends/cash flows and the firm's expected future cost of capital. The cost of capital is known as the investors' required return on capital as investors are the capital suppliers and have many investment choices for their capital. (a) If Coronavirus episode is expected to raise the business and financial risks and lower the future earnings of a U.S. financial firm, then what will be its effects on the two value drivers and the firm's current market value. (b) How would a drop in risk-free interest rate brought about by the Federal Reserve Bank affect the two value drivers and the firm's stock price?

Solutions

Expert Solution

(a) If Coronavirus episode is expected to raise the business and financial risks and lower the future earnings of a U.S. financial firm, then:

  • Future growth rate of cash flows will decline and this will lead to a decline in the firms stock price
  • As the risks will increase, the investors would expect a higher return on their investment (basic risk-return trade-off). If investors expect a higher return, this will increase the firms cost of capital

The market value of the firm is a direct function of its share price. So if the stock price falls because of the above two factors, the firms market value will also fall.

(b) A drop in risk-free interest rate brought about by the Federal Reserve Bank will affect the two drivers in the following manner:

  • Future cash flows are discounted by dividing them with the risk-free interest rate. So, a drop in the risk-free interest rate will increase the present value of the future cash flows and therefore increase the future growth rate of cash flows
  • If the risk-free rates drop, then the investors will perceive the firm as relatively lower risk as compared to the risk-free return, and would be happy to invest in the firm even at a lower return. Therefore the cost of capital will decrease

The market value of the firm is a direct function of its share price. So if the stock price rises because of the above two factors, the firms market value will also rise.

jeff jeffy answered 1 year ago
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