Question

Case study

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

• Capital Cities ABC, Inc., bonds, which have a par value of $1,000 and coupon interest rate of 8.75%, are selling for $1,314 and mature in 12 years.
• Southwest Bancorp preferred stock is paying dividend of $2.50 and selling for $25.50.
• Emerson Electric common stock is selling for $36.75. The stock recently paid a $1.32 dividend, and the firm’s earning per share have increased from $1.49 to 3.06 in the past five years. The firm expects to grow at the same rate for the foreseeable future.

   Your required rates of return for these investments are 6% for bonds, 7% for the preferred stock,   and 20% for the common stock.

Required:

PLEASE answer in steps and formulas

1. Calculate the value of each investment based on your required rate of return.
2. Which investment would you select? Why?
3. Assume Emerson Electric’s managers expect an earnings downturn and a resulting decrease in growth of 3%. How does this affect your answers to parts 1 and 2?
4. What required rates of return would make you indifferent to all three options?

Answer 1

1	BOND				INCREMENTAL RETURN	GROWTH
	PRICE	1000			EXPECETD LESS REQUIRED)	DOWN 3%
	MARKET PRIC	1314
	INTEREST RATE	8.75%
	RETURN	(INTEREST+CAPAITAL APPRECIATION)/OPENING NAV
		(87.50*12+(1314-1000))/12
	RETUEN	11.37%	REQUIRED RETUN	6%	5.37%	8.37%
	PREFERENEC SHARES
	DIVIDEND	2.5
	MARKET VALUE OF PREFERENCE SHARES	25.5
	RETURN FROM F PREFERENCE SHARES	DIVIDEND/MARKET VALUE P.SHARE
		2.50/25.50
		9.80%	REQUIRED RETUN	7%	2.80%	9.80%
	EQUITY SHARES
	DIVIDEND	1.32
	SELLING RATE	36.75
	EPS	3.06
	EARLIER EPS	1.49
	GROWTH	(3.06-1.49)/1.49/5
		21.1%
	RETURN OF EQUITY
	PRICE	DIVIDEND(RETURN LESS GROWTH)
		36.75=1.32(RETURN-21.10%)
		(-7.75)+36.75 8 RETURN=1.32
	SO RETURN IS	24.69%	REQUIRED RETUN	20%	4.69%	21.6900%
2	FROM THE ANALYSIS UNDERSTAND THAT INVESTMENT IN BONDS SHOWS MORE RETURN
3	THEN SHOULD BE SELECTE OPTION PREFERENCE SHARES INVESTMNET , SO THE FIRM GET A CONSTANT RETURN