Question

You have finally saved​ $10,000 and are ready to make your first investment. You have the three following alternatives for investing that​ money:

• A Microsoft bond with a par value of ​$1000 that pays 9.75 percent on its par value in​ interest, sells for ​$1,213.93​ , and matures in 99 years.

• Southwest Bancorp preferred stock paying a dividend of ​$3.34 and selling for ​$28.92.

• Emerson Electric common stock selling for ​$63.46​, with a par value of​ $5. The stock recently paid a ​$1.18 ​dividend, and the​ firm's earnings per share has increased from ​$2.22 to ​$3.87 in the past 5 years. The firm expects to grow at the same rate for the foreseeable future.

Your required rates of return for these investments are 4.50 percent for the​ bond, 10.00 percent for the preferred​ stock, and 14.00 percent for the common stock. Using this​ information, answer the following questions.

a. Calculate the value of each investment based on your required rate of return.

b. Which investment would you​ select? Why?

c. Assume Emerson​ Electric's managers expect an earnings to grew at 1 percent above the historical growth rate. How does this affect your answers to parts ​(a​) and ​(b​)?

d. What required rates of return would make you indifferent to all three​ options?

(Round all to two decimal places)

Answer 1

Solution:

Please find below the excel solution to this.

For each investment option, I have done three things.

1- Calculated the implied return as per the current prices given. That is the return these instruments promise to give.

2 - Based on the expected return we have calculated the price of the instrument today. (note - it is also logical to think that, if expected return in less than implied return, the expected price will be higher than the current price)

3 - We have calculated the expected gain using current prices and expected prices.

a. Calculate the value of each investment based on your required rate of return.

Value of Bond with required return   2,151.72
Value of Preferred Stock with required return   33.4
Value of Stock with required return   58.77

b. Which investment would you​ select? Why?

I would select investment of Bond and Preferred Stock as they are trading at prices below my expected prices. (or their implied returns are above my expected return)

c.

Yes. With increase in 1% in expected earnings, the expected value of stock is 106.97 above its expected value. We can invest in stock as well

d.

The required rates that will make me indifferent in all three options are the implied rates of the instruments.

Bond = 8.02%, Preferred Stock = 11.55%, Stock = 13.83% (calculated with considering 1% additional growth)

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