CHAPTER 10 Stock Valuation 327 Mini-Case You have finally saved $10,000 and are
ID: 2791929 • Letter: C
Question
CHAPTER 10 Stock Valuation 327 Mini-Case You have finally saved $10,000 and are ready to make your first investment. You have the following three alternatives for invest- ing that money: 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 Capital Cities ABC, Inc., bonds, which $1,000 and a coupon interest rate of 8.75 percent, are selling a. Calculate the value of each investment based on your re- for $1,314 and mature in 12 years. have a par value of the following questions quired rate of return. Southwest Bancorp preferred stock is paying a dividend of b. Which investment would you select? Why $2.50 and selling for $25.50. e. Assume Emerson Electric's managers expect an earnings downturn and a resulting decrease in growth of 3 percent Emerson Electric common stock is selling for $36.75. The stock recently paid a $1.32 dividend, and the firm's earn How does this affect your answers to parts a and b? ings per share have increased from $1.49 to $3.06 in the past five years. The firm expects to grow at the same rate all for the foreseeable future. d. What required rates of return would make you indifferent to three options?Explanation / Answer
Assumed bonds interest is paid anually Yearly interest per bond 87.5 Value of the Bond=87.5*(PVIF,6%,12)+1000*(PVIF,6%,12) Value of the bond=1230.56 Since it is selling for $1,314 yield is lesser than 6% so not acceptable Year Inflow Dis Fact PV 1 87.5 0.9434 82.54717 2 87.5 0.8900 77.87469 3 87.5 0.8396 73.46669 4 87.5 0.7921 69.3082 5 87.5 0.7473 65.38509 6 87.5 0.7050 61.68405 7 87.5 0.6651 58.1925 8 87.5 0.6274 54.89858 9 87.5 0.5919 51.79112 10 87.5 0.5584 48.85954 11 87.5 0.5268 46.09391 12 1087.5 0.4970 540.4542 NPV 1230.556 Preferred Stock Kp=D/P0 =2.5/25.50 Return on Pref 9.80% Since required rate of retirn is 7% referred stock can be accepted c= return on stock of Emerson Electric P0 36.75 D-5=1.49 D0=3.06 growth rate 1.49*(1+r)^5 r=15.5% Ke=D0*(1+g)/p0+g = 3.06*(1+0.155)/36.75+0.155 25.12% Since requited rate of return is 15% this option can also be accepted b. We can accept preferred stock & equity stock because in bothe the cases actural rate of return is higer than the required return c. If growth decrease by 3% even than actutal return will be 22.12% i.e. (25.12%-3%) which still higher than the required return , so it is accetable d. When all the three options have same rate of return in this case the return on stock is 25.12% so required rate of return will be 25.12%