This mini case is available in my finance lab. you have finally saved $10,000 an

Question

This mini case is available in my finance lab. you have finally saved $10,000 and are ready to make your first investment. you have the three following for the money the three following alternatives for investing the money: A Microsoft bond with a par value of $1,000 that pays 4.2 percent on its par value in interest, sells for $1, 115, and matures in 4 years. Southwest banker preferred stock paying a dividend of $2.63 and selling for $26.25. Emerson Electric common stock selling for $60, with a par value of $5. The stock recently paid a $1.88 dividend, and the firm's earnings per share has increased from $2.27 to $3.78 in the past 5 years. The firm expects to grow at the same rate for the foreseeable future. Your required rates of return for these investments are 3 percent for the bond, 5 percent for the preferred stock, and 12 percent for the common stock. Using this information, answer the following questions. Calculate the value of each investment based on your required rate of return. Which investment would you select? Why? Assume Emerson Electric's managers expect earnings to grow at 1 percent above the historical growth rate. How does this assumption affect your answers to parts (a) and (b)? What required rates of return would make you indifferent to all three options?

Explanation / Answer

Part A)

The value of each investment is determined as follows:

Bond

The value of bond can be calculated with the use of Present Value (PV) function/formula of EXCEL/Financial Calculator. The function/formula for PV is PV(Rate,Nper,PMT,FV) where Rate = Required Return, Nper = Period, PMT = Annual Coupon Payment and FV = Face Value of Bonds.

Here, Rate = 3%, Nper = 4, PMT = 1,000*4.2% = $42 and FV = $1,000

Using these values in the above function/formula for PV, we get,

Value of Bond = PV(3%,4,42,1000) = $1,044.61

_______

Value of Preferred Stock

The value of preferred stock can be calculated as follows:

Value of Preferred Stock = Annual Dividend/Required Return = 2.63/5% = $52.60

_______

Value of Equity

To calculate the value of equity, we need to determine the growth rate with the use of information provided for EPS. The growth rate can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (if any), PV = Current Value of EPS and FV = Future Value of EPS.

Here, Nper = 5, PMT = 0, PV = 2.27 and FV = 3.78

Using these values in the above function/formula for Rate, we get,

Growth Rate = Rate(5,0,-2.27,3.78) = 10.74%

Now, we can calculate the value of equity as follows:

Value of Equity = Dividend*(1+Growth Rate)/(Required Return - Growth Rate) = 1.88*(1+10.74%)/(12%-10.74%) = $165.23

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Part B)

Based on the calculations performed in Part A), I would prefer to invest the money in either Preferred Stock or Equity as both are currently selling at a price which is less than the value of investments based on required rates of return.

_______

Part C)

With 1% incremental growth rate in EPS, the revised growth rate will be 11.74% (10.74% + 1%) and the value of equity will be:

Revised Value of Equity = 1.88*(1+11.74%)/(12%-11.74%) = $807.97

As per the revised calcuations, the stock is highly undervalued. Therefore, I would prefer to invest in Equity only and would not consider the option of preferred stock.

_______

Part D)

The rates at which you will be indifferent are calculated as follows:

Bond

The rate can be calculated with the use of Rate function/formula of EXCEL/Financial Calculator. The function/formula for Rate is Rate(Nper,PMT,-PV,FV) where Nper = Period, PMT = Payment (if any), PV = Current Value of EPS and FV = Future Value of EPS.

Here, Nper = 4, PMT = 42, PV = $1,115 and FV = 1,000

Using these values in the above function/formula for Rate, we get,

Indifferent Rate = Rate(4,42,-1115,1000) = 1.24%

_______

Preferred Stock

The rate is calculated with the use of following formula:

Indifferent Rate = Annual Dividend/Current Selling Price*100 = 2.63/26.25*100 = 10.02%

_______

Equity

The rate is calculated as follows:

Indifferent Rate = Dividend*(1+Growth Rate)/Current Selling Price + Growth Rate = 1.88*(1+10.74%)/60 + 10.74% = 14.21%

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