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 ​$1,000 that pays 8.00 percent on its par value in​ interest, sells for ​$1,150.62​, and matures in 18 years. Southwest Bancorp preferred stock paying a dividend of ​$2.33 and selling for ​$29.71. Emerson Electric common stock selling for ​$58.67​, with a par value of​ $5. The stock recently paid a ​$1.01 ​dividend, and the​ firm's earnings per share has increased from ​$2.38 to ​$3.88 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 6.50 percent for the​ bond, 6.50 percent for the preferred​ stock, and 13.00 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?

Answer 1

Part (a)

Assume annual coupon payment on the bond:

Price of the bond = - PV (Rate, period, PMT, FV) = - PV (6.50%, 18, 8% x 1000, 1000) = $  1,156.49

Price of the preferred stock = Annual dividend / Required rate of return on preferred stock = 2.33 / 6.50% = $  35.85

Price of common stock = D0 x (1 + g) / (Ke - g)

g = (3.88 / 2.38)^1/5 - 1 = 10.27%

Price of common stock = 1.01 x (1 + 10.27%) / (13% - 10.27%) = $  40.77

Part (b)

Instrument	Price at Required return ($)	Current Price ($)	Conclusion	Will I invest?
Bond	1,156.49	1,150.62	Underpriced,	Yes
Preferred stock	35.85	29.71	Underpriced, extent of underpricing is high	Yes
Common stock	40.77	58.67	Overpriced	No

Part (c)

g = 1% higher than before = 1% + 10.27% = 11.27%

Price of commons stock = 1.01 x (1 + 11.27%) / (13% - 11.27%) = $  64.90

Part (a) answer will change to $ 64.90

The stock will now be trading at a price lower than expected price. Hence, my answer to part (b) will change. I will now select common stock for investment as well.

Part (d)

Required rate of return that will make us indifferent among the three options will be the current prevailing return on each of the three instruments:

• For bond, the required rate of return = YTM = RATE (Period, PMT, PV, FV) = RATE (18, 8% x 1000, -1150.62, 1000) = 6.55%
• For preferred stock, required return = Annual dividend / current price = 2.33 / 29.71 = 7.84%
• For common stock, required return = D1 / P + g = 1.01 x (1 + 10.27%) / 58.67 + 10.27% = 12.17%