Incorrect Q. A company\'s $100 par value perpetual preferred stock has a dividen
ID: 2617180 • Letter: I
Question
Incorrect Q. A company's $100 par value perpetual preferred stock has a dividend rate of 7% and a required rate of return of 11%. The company's earnings are expected to grow at a constant rate of 3% per year. If the market price per share for the preferred stock is $75, the preferred stock is most appropriately described as being Correct answerYour answer A. overvalued by $11.36 B. undervalued by $15.13 C. undervalued by $36.36 Solution Time Spent: 2 min 37 sec A is correct. Difficulty Level: Unrated Value of perpetual preferred stock Dividend Required rate of return $63.64 0.11 The stock is overvalued by $75.00 63.64 $11.36 B is incorrect because it uses the constant growth model 0.11-003 $90.13Explanation / Answer
Constant growth model has one peculiar factor - Growth.
See, equity dividends are expected to grow with earnings. Preferred dividends, on the other hand, are fixed dividends meaning they do not change with growth. They remain the same irrespective of the growth being positive or negative. And, since their is no growth, we can't use the constant growth model.