# Preferred Stock of Required Return

Question 1

The preferred stock of Gapers Inc. pays an annual dividend of $6.50. What is the price of the preferred stock if the required return is:

(a) 6%

(b) 8%

(c) 10%

Question 2

Marcia Stubern is planning for her golden years. She will retire in 20 years, at which time she plans to begin withdrawing $60,000 annually. She is expected to live for 20 years following her retirement. Her financial advisor thinks she can earn 9% annually. How much does she need to invest each year to prepare for her financial needs after her retirement?

Question 3

Which of the following financial assets is likely to have the highest required rate of return based on risk?

a.corporate bond.

b.Treasury bill.

c.Certificate of Deposit.

d.common stock.

Question 4

Ali Shah sets aside 2,000 each year for 5 years. He then withdraws the funds on an equal annual basis for the next 4 years. If Ali wishes to determine the amount of the annuity to be withdrawn each year, he should use following two tables in this order:

a.present value of an annuity of $1; future value of an annuity of $1

b.future value of an annuity of $1; present value of an annuity of $1

c.future value of an annuity of $1; present value of a $1

d.future value of an annuity of $1; future value of a $1

Question 5

Joe Nautilus has $120,000 and wants to retire. What return must his money earn so he may receive annual benefits of $20,000 for the next 14 years.

a.12%

b.Between 12% and 13%

c.14%

d.Greater than 15%

Question 6

As the discount rate becomes higher and higher, the present value of inflows approaches

a.0

b.minus infinity

c.plus infinity

d.need more information

Question 7

A 15-year bond pays 11% on a face value of $1,000. If similar bonds are currently yielding 8%, what is the market value of the bond? Use annual analysis.

a.Over $1,000

b.Under $1,000

c.Over $1,200

d.Not enough information to tell.

Question 8

As the compounding rate becomes lower and lower, the future value of inflows approaches

a.0

b.the present value of the inflows

c.infinity

d.need more information

Question 9

You are to receive $12,000 at the end of 5 years. The available yield on investments is 6%. Which table would you use to determine the value of that sum today?

a.Present value of an annuity of $1

b.Future value of an annuity

c.Present value of $1

d.Future value of $1

Question 10

The dividend on preferred stock is most similar to:

a.common stock with no growth in dividends.

b.common stock with constant growth in dividends.

c.common stock with variable growth in dividends.

d.Certificate of Deposit.

Question 11

A 30-year zero-coupon bond that yields 12% percent is issued with a $1000 par value. What is the issuance price of the bond (round to the nearest dollar)?

a.$33

b.$83

c.$8333

d.$none of the above

Question 12

The risk premium is likely to be highest for

a.U.S. government bonds.

b.corporate bonds.

c.gold mining expedition.

d.either b or c

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#### Solution Preview

Fin 3

Question 1

The preferred stock of Gapers Inc. pays an annual dividend of $6.50. What is the price of the preferred stock if the required return is:

(a) 6%

(b) 8%

(c) 10%

Answer:

Assuming the par value of the preference share is $100,

(a) 6% - $ 108.33 ($100*6.5/6)

(b) 8% - $ 81.25 ($100*6.5/8)

(c) 10% - $ 65.00 ($100*6.5/10)

Question 2

Marcia Stubern is planning for her golden years. She will retire in 20 years, at which time she plans to begin withdrawing $60,000 annually. She is expected to live for 20 years following her retirement. Her financial advisor thinks she can earn 9% annually. How much does she need to invest each year to prepare for her financial needs after her retirement?

Answer: $10,706, assuming the withdrawal from the 21st year will be made at the beginning of the year.

Question 3

Which of the following financial assets is likely to have the highest required rate of return based on risk?

a.corporate ...

#### Solution Summary

Question 1

The preferred stock of Gapers Inc. pays an annual dividend of $6.50. What is the price of the preferred stock if the required return is:

(a) 6%

(b) 8%

(c) 10%

Answer:

Assuming the par value of the preference share is $100,

(a) 6% - $ 108.33 ($100*6.5/6)

(b) 8% - $ 81.25 ($100*6.5/8)

(c) 10% - $ 65.00 ($100*6.5/10)

Question 2

Marcia Stubern is planning for her golden years. She will retire in 20 years, at which time she plans to begin withdrawing $60,000 annually. She is expected to live for 20 years following her retirement. Her financial advisor thinks she can earn 9% annually. How much does she need to invest each year to prepare for her financial needs after her retirement?

Answer: $10,706, assuming the withdrawal from the 21st year will be made at the beginning of the year.

Question 3

Which of the following financial assets is likely to have the highest required rate of return based on risk?

a.corporate bond.

b.Treasury bill.

c.Certificate of Deposit.

d.common stock.

Answer: d.common stock

Question 4

Ali Shah sets aside 2,000 each year for 5 years. He then withdraws the funds on an equal annual basis for the next 4 years. If Ali wishes to determine the amount of the annuity to be withdrawn each year, he should use following two tables in this order:

a.present value of an annuity of $1; future value of an annuity of $1

b.future value of an annuity of $1; present value of an annuity of $1

c.future value of an annuity of $1; present value of a $1

d.future value of an annuity of $1; future value of a $1

Answer: b.future value of an annuity of $1; present value of an annuity of $1

Question 5

Joe Nautilus has $120,000 and wants to retire. What return must his money earn so he may receive annual benefits of $20,000 for the next 14 years.

a.12%

b.Between 12% and 13%

c.14%

d.Greater than 15%

Answer: c.14%

Question 6

As the discount rate becomes higher and higher, the present value of inflows approaches

a.0

b.minus infinity

c.plus infinity

d.need more information

Answer: a.0

Question 7

A 15-year bond pays 11% on a face value of $1,000. If similar bonds are currently yielding 8%, what is the market value of the bond? Use annual analysis.

a.Over $1,000

b.Under $1,000

c.Over $1,200

d.Not enough information to tell.

Answer: c.Over $1,200

Question 8

As the compounding rate becomes lower and lower, the future value of inflows approaches

a.0

b.the present value of the inflows

c.infinity

d.need more information

Answer: b.the present value of the inflows

Question 9

You are to receive $12,000 at the end of 5 years. The available yield on investments is 6%. Which table would you use to determine the value of that sum today?

a.Present value of an annuity of $1

b.Future value of an annuity

c.Present value of $1

d.Future value of $1

Answer: c.Present value of $1

Question 10

The dividend on preferred stock is most similar to:

a.common stock with no growth in dividends.

b.common stock with constant growth in dividends.

c.common stock with variable growth in dividends.

d.Certificate of Deposit.

Answer: d.Certificate of Deposit.

Question 11

A 30-year zero-coupon bond that yields 12% percent is issued with a $1000 par value. What is the issuance price of the bond (round to the nearest dollar)?

a.$33

b.$83

c.$8333

d.$none of the above

Answer: a.$33

Question 12

The risk premium is likely to be highest for

a.U.S. government bonds.

b.corporate bonds.

c.gold mining expedition.

d.either b or c

Answer: d.either b or c

Finance: Bond Valuation, Dividend Discount Model, Return on Preferred Stock, Valuation, Risk

A 1: (Bond valuation) A $1,000 face value bond has a remaining maturity of 10 years and a required return of 9%. The bond's coupon rate is 7.4%. What is the fair value of this bond?

A 2: (Dividend discount model) Assume RHM is expected to pay a total cash dividend of $5.60 next year and its dividends are expected to grow at a rate of 6% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10%?

A 3: (Required return for a preferred stock) James River $3.38 preferred is selling for $45.25. The preferred dividend is non growing. What is the required return on James River preferred stock?

A 4: (Stock valuation) Suppose Toyota has non maturing (perpetual) preferred stock outstanding that pays a $1.00 quarterly dividend and has a required return of 12% APR (3% per quarter). What is the stock worth?

B 16: (Interest-rate risk) Philadelphia Electric has many bonds trading on the New York Stock Exchange. Suppose PhilEl's bonds have identical coupon rates of 9.125% but that one issue matures in 1 year, one in 7 years, and the third in 15 years. Assume that a coupon payment was made yesterday.

1. If the yield to maturity for all three bonds is 8%, what is the fair price of each bond?

2. Suppose that the yield to maturity for all of these bonds changed instantaneously to 7%. What is the fair price of each bond now?

3. Suppose that the yield to maturity for all of these bonds changed instantaneously again, this time to 9%. Now what is the fair price of each bond?

4. Based on the fair prices at the various yields to maturity, is interest-rate risk the same, higher, or lower for longer-versus shorter-maturity bonds?

B 18: (Default risk) You buy a very risky bond that promises a 9.5% coupon and return of the $1,000 principal in 10 years. You pay only $500 for the bond.

1. You receive the coupon payments for three years and the bond defaults. After liquidating the firm, the bondholders receive a distribution of $150 per bond at the end of 3.5 years. What is the realized return on your investment?

2. The firm does far better than expected and bondholders receive all of the promised interest and principal payments. What is the realized return on your investment?

B 20: (Constant growth model) Medtrans is a profitable firm that is not paying a dividend on its common stock. James Weber, an analyst for A. G. Edwards, believes that Medtrans will begin paying a $1.00 per share dividend in two years and that the dividend will increase 6% annually thereafter. Bret Kimes, one of James' colleagues at the same firm, is less optimistic. Bret thinks that Medtrans will begin paying a dividend in four years, that the dividend will be $1.00, and that it will grow at 4% annually. James and Bret agree that the required return for Medtrans is 13%.

1. What value would James estimate for this firm?

2. What value would Bret assign to the Medtrans stock?

Problem: (Beta and required return) The risk less return is currently 6%, and Chicago Gear has estimated the contingent returns given here.

1. Calculate the expected returns on the stock market and on Chicago Gear stock.

2. What is Chicago Gear's beta?

3. What is Chicago Gear's required return according to the CAPM?

Realized Return

State of the Market Probability that State Occurs Stock Market Chicago Gear

Stagnant 0.20 (10%) (15%)

Slow growth 0.35 10 15

Average growth 0.30 15 25

Rapid growth 0.15 25 35