Examples - chapter 8

1. (Preferred Stock Valuation) Grees preferred stock is selling for $35 in the market and pays a
$4 annual dividend.
a. What is the expected rate of return of the stock?
b. If an investors required rate of return is 10 percent, what is the value of the stock
to the investor?
c. Should the investor acquire the stock?
Answer
a. 11.43%
b. $40
c. Yes
2. (Common Stock Valuation): Answer 3 above questions, but for common stocks that paid
$1 of dividend last year, dividends are expected to grow at an 8 percent annual rate for an
indefinite number of years, current market price is $25, and your required rate of return is 11
percent
Solution:
a. Expected Rate of Return =
Dividend in Year 1
Market Price
+
Growth
Rate

=
$1.00(1.08)
$25.00
+ 0.08 = 0.1232 = 12.32%
b. The Value to the investor=
Dividend in Year 1
Required Rate of Return - Growth Rate
=
$1.00(1.08)
0.11 - 0.08
= $36.00
c. Yes, the expected rate of return is greater than your required rate of return
(12.32 percent versus 11 percent). Also, your value of the stock ($36.00) is larger
than the current market price ($25.00).