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 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 Bancorp 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. 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 earnings to grow at 1 percent above the historical growth rate. How does this assumption affect your answers to parts (a) and (b)? d. What required rates of return would make you indifferent to all three options?

Explanation / Answer

For Microsoft bonds, rate of return can be calculated using I/Y function on a calculator or RATE in excel

N = 4, PMT = 4.2% x 1000 = 42, PV = -1,115, FV = 1000 => Compute I/Y = 1.24%

Given your rate of 3%, bond price can be calculated using PV function

N = 4, PMT = 42, I/Y = 3%, FV = 1000 => Compute PV = $904.10

For Southwest preferred stocks,

Rate of return = Dividend / Price = 2.63 / 26.25 = 10.02%

Value = Dividend / Rate = 2.63 / 5% = $52.60

For Emerson stock, growth rate, g = (EPS5 / EPS1)^(1/5) - 1 = (3.78 / 2.27)^(1/5) - 1 = 10.74%

Using dividend growth model, Rate of return, r = D0 x (1 + g) / P + g = 1.88 x (1 + 10.74%) / 60 + 10.74% = 14.21%

Value = D0 x (1 + g) / (r - g) = 1.88 x (1 + 10.74%) / (12% - 10.74%) = $164.85

Return Value Microsoft 1.24% $904.10 Southwest 10.02% $   52.60 Emerson 14.21% $ 164.85

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.