You have finally saved $10,000 and are ready to make your first investment. You

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:
• Capital Cities ABC, Inc. bonds with a par value of $1,000, that pays an 8.75 percent on its par value in interest, sells for $1,314, and matures in 12 years.
• Southwest Bancorp preferred stock paying a dividend of $2.50 and selling for $25.50.
• Emerson Electric common stock selling for $36.75, with a par value of $5. The stock recently paid a $1.32 dividend and the firm's earnings per share has increased from $1.49 to $3.06 in the past five years. The firm expects to grow at the same rate for the foreseeable future.

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 question.

1. Which investment would you select? Why?

Explanation / Answer

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.

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