Book: Keown, A., Martin, J., & Petty, J. (2011). Foundations of finance (7th ed.
ID: 2691867 • Letter: B
Question
Book: Keown, A., Martin, J., & Petty, J. (2011). Foundations of finance (7th ed.). Boston, MA: Prentice Hall. ISBN: 9780136113652 Review the financial information in the Chapter 8 Mini Case on page 232 of your text. Answer the following questions in an Excel document. Solve using Excel formulas (preferred) or clearly write out the steps you took to calculate your answers. Round any dollar amounts to the nearest dollar ($1,500,074) and any percentages to two decimals (9.56%). Calculate the value of each investment based on your required rate of return. Which investment would you select? Why? Assume Emerson ElectricExplanation / Answer
a) Bond Par ----------------------------------$1,000.00 IR --------------------------------------7.625% Maturity ----------------------------- 10 Price ---------------------------- $ 986.00 Required Rate of Return ----------- 6.00% Value to You ------------------- $1,120.88 use a financial calculator to determine PV Note I assumed semi-annual payments Preferred Stock Par -------------------------------------$ 50.00 Dividend --------------------------------$ 2.81 Current Price---------------------------$ 39.00 Required Rate of Return-----------------7.00% Value to You -----------------------$ 40.18 (given by $2.81/.07 as this is a perpetuity) Common Stock Price------------------------------$ 80.00 Dividend---------------------------$ 2.10 Latest EPS-------------------------$ 4.48 EPS Growth Rate--------------------13.30% (4.48/2.40)^(1/5)-1 EPS Payout Ratio--------------------46.88% 2.10/4.48 Required Rate of Return-----------15.00% Stock Value to You-------------$ 139.60 Using D1/(k-g), $4.48*(1+13.3%)* (46.88%)/(15%-13.3%) b) Given a risk-neutral investor, the investor should select the common stock as it has the most excess NPV to the investor over and above the market price. However, this choice might not be appropriate if the investor's risk tolerance is not high enough. See answer to part (C). c) Assumed Value if Growth Declines 3%------ $ 49.24 The answer above is given by a modification of D1/(k-g) If D1 = EPS * (1+g) * (1-Payout Ratio) then the value is given by: 4.48 * (1+13.3%-3%) * 46.88% / (15%-(13.3%-3%)) This would obviously make the common stock an unattractive investment as the value to you would be below the market price. However, the market price would probably also change in reaction to this information. d) The required rate of return that would make one indifferent to all three options would be the one that sets the price of the security (to you) equal to its market value (thereby creating no excess return) Bond Rate to Set Value Equal to $986----7.83% use a financial calculator to obtain the above. Preferred Required Rate to XXXXX to $39----7.21% =2.81/39 Common Required Rate to XXXXX to $80-----16.27%