You have finally saved $10,000 and are ready to make your first investment. You
ID: 2666519 • Letter: Y
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:A CBS bond with a par value of $1,000, an interest rate of 7.625 percent, and a maturity of 10 years. The bond is selling for $986.
Alabama Power Company preferred stock with a $50 par value and a dividend of $2.8125 per year. The stock is currently trading at $39 per share.
Emerson Electric common stock that is selling for $800 with a par value of $5. This stick recently paid a $2.10 dividend, and the firm's earnings per share have increased from $2.40 to $4.48 in the past 5 years. An equivalent amount of growth in the dividend is expected.
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 expect an earnings downturn and a resulting decrease in growth of 3 percent. How does this affect your answers to parts 1 and 2?
d. What required rates of return would make you indifferent to all three options?
Explanation / Answer
A CBS bond with a par value of $1,000, an interest rate of 7.625 percent, and a maturity of 10 years, the bond is selling for $986.
Par Value of the bond = $1,000
Interest rate (or) Coupon Rate = 7.625%
Number of years to Maturity = 10 years
Current Market value of the bond = $986
Yield to Maturity (YTM) (or) Required Rate of Return = 6%
Calculating Current Market Value of the bond:
Calculating Current Market Value of the bond (PV):
Using Ms-Excel "PV" Function:
Interest Rate (or) Yield to Maturity of the bond (Rate) 6%
Number of Periods to maturity (Nper) 10
Annual Coupon Payment (PMT) [$1,000 * 7.625%] -76.25
Par Value (or) Face Value (or) Future Value of the bond (FV) -1000
Current Market Value of the bond (PV) $1,119.60
Total Investment Amount you have ready to invest = $10,000
Par Value of the bond = $1,000
Number of bonds = [$10,000 / $1,000]
Number of bonds = 10 bonds
Total Value of the Investment = [10 bonds $1,119.60]
Total Value of the Investment = $11,196
Alabama Power Company preferred stock with a $50 par value and a dividend of $2.8125 per 61 year. The stock is currently trading at $39 per share.
Par Value of Preferred Stock = $50 per share
Annual Preferred Dividend = $2.8125 per year
Number of years = 61 years
Current Preferred Stock Value = $39 per share
Cost of Preferred Stock = 7%
Calculating Current Preferred Stock value per share:
Total Investment Amount you have ready to invest = $10,000
Par Value of Preferred Stock = $50 per share
Number of Preferred Shares = [$10,000 / $50 per share]
Number of Preferred Shares = 200 shares
Preferred Stock Value = [D / R]
Preferred Stock value = [$2.8125 / 0.07]
Preferred Stock value = $40.1785
Total Value of Investment = [$40.1785 200 shares]
Total Value of Investment = $8,035.7
Total value of Investment (Bonds) = $11,196
Total value of investment (Preferred stock) = $8,035.70
Among those two investments; investments in the bonds is preferable, because investments in bonds is a better investment compared to investment on preferred stock.
(C) Assume Emerson Electrics Managers expect an earnings downturn and resulting decreases in growth of 3 percent.
Calculating Current Stock Value (P0):
Current Stock Value (P0) = [D1 / (R – g)]
Current Stock Value (P0) = [{$2.50 + ($2.50 * 0.866)} / (0.15 – (-0.03)]
Current Stock Value (P0) = [$4.66 / 0.18]
Current Stock Value (P0) = $25.88
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