Question

1. You are considering three investments. The first is a bond that is selling in the market at $1 200. The bond has a $1 000 par value, pays interest at 8% and is scheduled to mature in 10 years. For bonds of this risk class you believe that a 9% rate of return should be required.

The second investment that you are analyzing is a preferred stock ($125 par value) that sells for $120 and pays an annual dividend of $18. Your required rate of return for this stock is 16%.

The last investment is a common stock that recently paid a $2 dividend. The firm expects to pay a dividend of $2.18 at year end and this growth in dividends per share is expected for the indefinite future. The stock is selling for $20 and you think a reasonable required rate of return for the stock is 20%.

Required:

1. Calculate for each security

1. Expected rate of return                                                                                         
2. The current value based on your required rate of return                     

Which of the investment(s) should you accept? Why?

Answer 1

ANS = 1)

- Expected rate of return on bond = [Cashflow + (FV - PV) / time) ] / [(FV + PV ) / 2]. FV = 1000 , PV=1200   cashflow= 80 , Time =10.  

= Expected rate of return on bond = { 80 + [( 1000 - 1200) / 10] } / [ (1200 +1000) / 2 ] = 0.0545 0r 5.45%.

- Expected rate of return on preferred stock = dividend / current price. dividend= 18 , current price = 120. = Expected rate of return on preferred stock = 18 / 120 = 0.15 or 15%.

- Expected rate of return on equity = ( forcasted dividend / current price ) + growth. forcasted dividend = 2.18 , growth = ( 2.18 / 2 ) -1 = 0.09 or 9% , current price = 20.

= Expected rate of return on equity = ( 2.18 / 20 ) +0.09 = 0.1990 0r 19.90%

2) We would prefer investment in common stock as the calculated expected rate of return is equal to the investor rate of return i.e 20%. we won't choose other securities as the calculated rate of return is less than the investor rate of return. Hence bond and preferred share seems to be overvalued for the given rate of return in question whereas common stock is accurately valued.