An issue of preferred stock is paying an annual dividend of $5. The growth rate for the firm’s common stock is 14%. What is the preferred stock price if the required rate of return is 11%?
- A) $45.45
- B) $41.67
- C) $35.71
- D) $30.12
“
M
The answer is A. The question is trying to confuse you by giving you too much information. We don’t care what the common stock is doing so forget the growth of 14%. All we care about is the preferred annual dividend. Since the annual dividend is constant and the same, we can use the present value of a perpetuity (sounds hard, but it isn’t)
PV = pmt / discount rate
Or
Intrinsic Value (of preferred stock in this case) = dividend / discount rate
Intrinsic Value = $5 / 0.11
Intrinsic Value = $45.45
See we don’t want to by this preferred stock unless we can get at least an 11% return off of it. So what price will a $5 dividend yield an 11% return?
Payment / Price = Yield
$5 / $45.45 = .11 (or 11%)
So there you have it, $45.45
.”
David Lin, Professeur
“A) $45.45”
jeff410