Question

1a. The last dividend Company X paid was $ 5 and the constant growth rate of dividends is 2%. The current price of this stock is $20 per share. What is the required rate of return (yield) on that stock?

A		27.5%
B		15%
C		8%
D		35%

1b. Your first investment is Stock A. 3 years ago you bought Stock A from $20 and sold it now at $25. Over the three years you received a cash dividend of $3.

Your second investment is Stock B. 4 years ago you bought Stock B from $31 and sold it now at $40. Over the four years you received a cash dividend of $5.

Which one is a better investment?

A		Stock A
B		Stock B
C		You are indifferent because both Stock A and Stock B had the same financial performance.
D		None

1c. A preferred stock is paying annual dividend of $5 forever. What is the price of this preferred stock if the yield (required rate of return on this preferred stock) is 10%?

A		$ 2
B		$ 20
C		$ 5
D		$ 50

Answer 1

Solution:

1a)Calculation of required rate of return(Ke)

Last year dividend(D0)=$5

D1=D0(1+growth rate)=$5(1+0.02)

=$5.10

Share Price=D1/(Ke-Growth rate)

Ke(Required rate)=(D1/Share Price)+Growth rate

=($5.10/$20)+0.02

=0.275 or 27.50%

Thus correct answer is Option A i.e 27.50%

Thus,required rate of return (yield) on stock is 27.50%

1b)We can evaluate the investments on the basis of annualized holding period return:

Holding Period Return(HPR)=[Income+(Sale Price-Purchase Price)]/Purchase Price

HPR of ;

Stock A=[$3+($25-$20)]/$20

=$8/20=0.40 or 40%

Stock B= $5+($40-$31)/$31

=$14/31=0.45 or 45%

Annualized HPR=[(1+HPR)^1/n]-1

Annualized HPR of:

Stock A=[(1+0.40)^1/3]-1

=0.1174 or 11.74%

Stock B=[(1+0.45)^1/4]-1

=0.0973 or 9.73%

Since the annualized HPR of stock A is higher than Stock B,hence investment in stock A is better.

Thus,correct answer is Option A i.e Stock A

1c)Calculation of price of this preferred stock

Price of this preferred stock=Dividend/Required rate of return

=$5/10%

=$50

Therefore correct answer is Option D i.e $50