RockTop Construction expects to pay a $1.10 dividend next year to its common sto

Question

RockTop Construction expects to pay a $1.10 dividend next year to its common stock holders. In each following year, common stock dividends will grow at 4%. RockTop pays its preferred shareholders a dividend of $2.25 every year. If common stock sells at $12.57 per share and preferred stock sells at $23.41 per share, what are the required returns on each type of stock? Why might an investor prefer preferred stock? Why might an investor prefer common stock?

Answer is preferred=9% and common=12.75% so please walk me through this so with formulas and explainations so that I can understand and do it on a test. Thanks

Explanation / Answer

Common stock

Price = D1/(re-g)

12.57 = 1.1/(re-4%)

re = 12.75%

required return on common stock = 12.75%

Preferred stock

Price = dividend/rp

23.41 = 2.25/rp

rp = 9.61%

required return on Preferred stock = 9.61%

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