Q. Explain how valuing preferred stock with a stated maturity differs from valui
ID: 2793347 • Letter: Q
Question
Q. Explain how valuing preferred stock with a stated maturity differs from valuing preferred stock with no maturity and calculate the price of a share of preferred stock under both conditions.
Q. What is the effective annual yield of a bond that promised an annual yield of 7.5% if this bond pays coupons twice a year?
Q. What is the EAC of two projects: project A, which costs $230 and is expected to last two years, and project B, which costs $300 and is expected to last three years? The cost of capital is 12%.
Explanation / Answer
Preferred stock with no maturity is also known as 'Perpetual preffered stock'.
Perpetual Preferred Stock
A perpetual preferred stock pays a fixed dividend for an indefinite period. Although a perpetual preferred stock does not have a specific buy-back date, the issuing corporation possesses the right to buy back the stock at any time under specific terms listed in the prospectus. Companies buy back shares for a variety of reasons, such as new tax laws and changes in interest rates. For example, a company may choose to buy back your preferred shares if interest rates fall below the yield the company is paying to preferred shareholders.
Non-Perpetual Preferred Stock
Non-perpetual preferred shares carry characteristics of stocks and bonds. The shares trade like common stock but have a maturity date like bonds. A non-perpetual stock carries a specific maturity date when the company will buy back shares from preferred stockholders at a specified price. The dividends paid to investors cease when the company buys back the shares. In many cases, non-perpetual preferred stocks carry a maturity term of 30 to 49 years
For Valuing the main differences come from the fact that in case of perpetual preferred stocks you have to incorporate dividends, growth factors, etc. for the indefinite future. However, for non-perpetual preferred stocks, there a certain maturity date. So while valuing these kind of stocks, you have to incorporate dividends, growth factors, etc only till the maturity date.
EAY = (1+(0.075/2))^2-1 = 7.64%
Use the 'PMT' function in Excel.
Project A:
EAC for project A = PMT(0.12,2,-230) = $136.09
EAC for project B = PMT(0.12,3,-300) = $124.9
where 0.12 is the cost of capital, (2,3) are the periods for each project
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