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. What required rates of return would make you indifferent to all three options?

Explanation / 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 pmts 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% I used goal seek in Excel using the formula I supplied for the price of the stock above. You could also solve this algebraically for the required rate of return (k).

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