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: Captial cities ABC, Inc. bonds with a par value of $1,000, that pays and 8.75 percent on its par value in interest, sells for $1,314, and marures in 12 years. southwest bancorp preferred stock paying a dividend f $2.50 and selling for $25.50. emerson electric common stock selling for $36.75, with a par value of $5. The stock recently paid a $1.32 dividend and the firm's earnings per share has increased from $1.49 to $3.06 in the past five years. the firm expects to grow at the same rate fr the foreseeable future. your required rates of return for these investments are 6 percent for the bond, 7 percent for the preferred stock, and 15 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 exect an earnings downturn and a resulting decrease in growth of 3 percent. how does this affect your answers to part a and be? d.) what required rates of return would make you indifferent to all options?

Answer 1

a). Bond price at required 6% return:

Coupon payment = 8.75%*par value = 8.75%*1,000 = 87.5

FV = 1,000; PMT = 87.5; N = 12; Rate = 6%, solve for PV. PV = 1,230.56

Preferred stock at required 7% return:

Price = Dividend/required return = 2.50/7% = 35.71

Common stock at required 15% return:

Growth rate g: 3.06 = 1.49*(1+g)^5

g = ((3.09/1.49)^(1/5)) -1 = 15.48%

Since g > required return, price cannot be calculated using constant growth model but we can say that its price will be greater than the current price.

b). Out of the 3 options, only the preferred stock is selling at a price lower than the one at your required return so it should be selected.

c). If g = 15.48%-3% = 12.48% then share price = D0*(1+g)/(r-g)

= 1.32*(1+12.48%)/(15%-12.48%) = 58.92.

Assuming that the selling price does not change, common stock should be bought now as its value is much more compared to its selling price.

d). If the required rates of return become equal to the current returns on the three securities then the buyer would be indifferent to the options.

YTM for the bond: PV = 1,314; PMT = 87.5; FV = 1,000; N = 12, solve for RATE. YTM = 5.17%

Current yield for the preferred stock = 2.50/25.50 = 9.80%

Return on the common stock = D0*(1+g)/P +g

= 1.32*(1+15.48%)/36.75 +15.48% = 4.15% + 15.48% = 19.63%