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Investement Valuation- Bonds, Common Stock, Preferred Stock

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You are considering three investments.

The first is a bond selling for $1,100: it has $1,000 par value, coupon rate of 13%, and 15-year maturity. For bonds in this risk class, it should offer 14% yield to maturity (rate of return).

The second is a preferred stock with $100 par value selling for $90 per share, with a $13 annual cash dividend - you require a 15% rate of return on this preferred stock.

The third is a common stock with $25 par value that pays a cash dividend of $2; earnings per share for the company increased from $3 to $6 over 10 years, and the growth in dividends will be the same as the growth in earnings per share. The market price of the stock is $20 per share, and you think a
reasonable rate of return on it is 20%.

A. Explain how to calculate the value of each security based on the stated required rate of return.

B. Which investment would you buy? Explain.

C. If your required rate of return changed to 12% for the bond, 14% for the preferred
stock, and 18% for the common stock, how would your answers to parts a and b
change? Don't do the calculations - explain how to do them.

D. Repeat part c with required rates of return of 20% on the common stock, with
anticipated constant growth rate changes to 12%.

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Solution Preview

Please find the attachment for a more effectively formatted solution. **Explain how to calculate the value of each security based on the stated required rate of return.**

Yield to maturity is the best measure of the return rate since it incorporates all aspects of the bond (including time-value of money). YTM formula looks like this:

Yield to Maturity= (C+ (F-P)/n)/((F+P)/2)

C= Coupon Payment (Face Value x Couple Rate)
F= Face Value
P= Price
n= Years to Maturity

Yield to Maturity= ($130+ ($1000-$1100)/15)/(($1000+$1100)/2)

Yield to Maturity= 11.7%

Preferred stock is typically valued by dividing the dividend by the required rate of return, (Miller, 2007). If not given, the annual dividend may expressed through a Par Value/Rate of Return relationship similar to bonds. In the example above, the dividend is given as $13.

Preferred Stock Value= (Annual Dividend)/(Required Rate of Return)
Preferred Stock Value= $13/0.15

Preferred Stock Value=$86.67

The Gordon model (or constant growth dividend discount model) is the easiest method to value common stock given the information above. The ...

Solution Summary

Evaluates three types of investment- Bond, Preferred Stock, and Common stock- and valuation methods of each. Detailed calcuations on finding risk-adjusted required rate of return. Includes bond yeild, stock dividend, and growth considerations. Formula and references included.

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1. Although corporate bonds have lower total annual returns per year than common stocks, corporate bonds are not risk free. For example, Enron's filing for bankruptcy in December 2001 was one of the largest bankruptcy filings in the U.S. The creditors received less than twenty cents on the dollar for their investments. Similarly, when WorldCom declared bankruptcy, its creditors received less than forty cents on the dollar for their investments. Bond investors who were just seeking income from their bond investments experienced significant principal losses.
What are some of the risks of investing in corporate bonds? Despite these risks, why do investors still invest in corporate bonds?

2. Corporations can finance themselves through many ways such as common stock, corporate debt, and preferred stock. The cost of common stock can be determined using the capital asset pricing model (CAPM). Not all common stocks pay a common stock cash dividend; however, it is quite common for a bond to pay interest. This bond interest payment is a major reason bond investors buy coupon-paying corporate bonds. The preferred stock financing option, however, is used less frequently by corporations compared to corporate debt and common stock financing options.
How does a corporate bond compare with preferred stock? How does the valuation of a corporate bond compare with the valuation of preferred stock?

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