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LOS c, (Part 1): Calculate and interpret the value of a preferred stock using the dividend discount model (DDM).fficeffice" />

Q1. A preferred stock’s dividend is $5 and the firm’s bonds currently yield 6.25%. The preferred shares are priced to yield 75 basis points below the bond yield. The price of the preferred is closest to:

A)   $5.00.

B)   $90.91.

C)   $80.00.

Correct answer is B)

Preferred stock yield (K_p) = bond yield – 0.75% = 6.25% ? 0.75% = 5.5%

Value = dividend / K_p = $5 / 0.055 = $90.91.

 

Q2. Assuming a discount rate of 15%, a preferred stock with a perpetual dividend of $10 is valued at approximately:

A)   $1.50.

B)   $66.67.

C)   $8.70.

Correct answer is B)

The formula for the value of preferred stock with a perpetual dividend is: D / kp, or 10.0 / 0.15 = $66.67.

 

Q3. Calculate the value of a preferred stock that pays an annual dividend of $5.50 if the current market yield on AAA rated preferred stock is 75 basis points above the current T-Bond rate of 7%.

A)   $42.63.

B)   $70.97.

C)   $78.57.

Correct answer is B)

k_preferred = base yield + risk premium = 0.07 + 0.0075 = 0.00775

Value_Preferred = Dividend / k_preferred

Value = 5.50 / 0.0775 = $70.97

 

Q4. A company has 8 percent preferred stock outstanding with a par value of $100. The required return on the preferred is 5 percent. What is the value of the preferred stock?

A)   $160.00.

B)   $152.81.

C)   $100.00.

Correct answer is A)

The annual dividend on the preferred is $100(.08) = $8.00. The value of the preferred is $8.00/0.05 = $160.00.

 

Q5. If a preferred stock that pays a $11.50 dividend is trading at $88.46, what is the market’s required rate of return for this security?

A)   13.00%.

B)   11.76%.

C)   7.69%.

Correct answer is A)

From the formula: Value_{Preferred Stock} = D / k_p, we derive k_p = D / Value_{Preferred Stock} = 11.50 / 88.46 = 0.1300, or 13.00%.

 

Q6. A company has 6 percent preferred stock outstanding with a par value of $100. The required return on the preferred is 8 percent. What is the value of the preferred stock?

A)   $92.59.

B)   $75.00.

C)   $100.00.

Correct answer is B)

The annual dividend on the preferred is $100(.06) = $6.00. The value of the preferred is $6.00/0.08 = $75.00.

 

Q7. What is the value of a preferred stock that is expected to pay a $5.00 annual dividend per year forever if similar risk securities are now yielding 8 percent?

A)   $62.50.

B)   $40.00.

C)   $60.00.

Correct answer is A)

$5.00/.08 = $62.50.

 

Q8. The preferred stock of the Delco Investments Company has a par value of $150 and a dividend of $11.50. A shareholder’s required return on this stock is 14%. What is the maximum price he would pay?

A)   $150.00.

B)   $82.14.

C)   $54.76.

Correct answer is B)

Value of preferred = D / kp = $11.50 / 0.14 = $82.14