# You are considering three investments. The first is a bond that is ...

## Question

You are considering three investments. The first is a bond that is selling in the market at \$1,200. The bond has a \$1,000 par value, pays interest at 14 percent, and is scheduled to mature in 12 years. For bonds of this risk class, you believe that a 12 percent rate of return should be required. The second investment that you are analyzing is a preferred stock (\$100 par value) that sells for \$80 and pays an annual dividend of \$12. Your required rate of return for this stock is 14 percent. The last investment is a common stock (\$35 par value) that recently paid a \$3 dividend. The firmâ€™s earnings per share have increased from \$4 to \$8 in 9 years, which also reflects the expected growth in dividends per share for the indefinite future. (Use the FV formula to find out the growth rate.) The stock is selling for \$25, and you think a reasonable required rate of return for the stock is 20 percent.
1. Calculate the value of each security based on your required rate of return.
2. Which investment(s) should you accept? Why?
3. If your required rates of return changed to 13 percent for the bond, 16 percent for the preferred stock, and 18 percent for the common stock, how would your answers change to parts (1) and (2)?
4. Assuming again that your required rate of return for the common stock is 20 percent, but the anticipated constant growth rate changes to 5 percent, would your answers to parts (1) and (2) be different?
5. What is the expected rate of return on the three investment alternatives?

Bond             Preferred Stock                Common Stock
1.Value of the security based on
2.Which investment to accept:
3. Changed required rate of return.
New values:                                             13%                      16%                                    18%
3. Which investment to accept:
Value of common stock if required
rate of return is 20% and growth 5%:
Expected rate of return

## Solution Preview

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Valuation analysis
Bond Preferred Stock Common Stock
1.Value of the security based on your required rate of return: \$1,125.50 \$85.71 \$27.01
2.Which investment to accept: No Yes Yes
3. Changed required rate of return.
New values: 13%
\$1,059.95 16%
\$75 18%
\$32.42
3. Which investment to accept: No No Yes
Value of common stock if required rate of return is 20% and growth 5%: \$21, Not a good investment
Expected rate of return 10.96% 15% 20.97%
The value of the bond has been determined using the PV() function in Excel by discounting the future cash inflows at the rate of 12%. The value of preferred stock has been found using the formula of Annual dividend/Required return....

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