You have finally saved $10,000 and are ready to make your first investment. You

Question

You have finally saved $10,000 and are ready to make your first investment. You
have the three following alternatives for investing that money:
• A CBS bond with a par value of $1,000, an interest rate of 7.625 percent, and
a maturity of 10 years. The bond is selling for $986.
• Alabama Power Company preferred stock with a $50 par value and a dividend
of $2.8125 per year. The stock is currently trading at $39 per share.
• Emerson Electric common stock that is selling for $80 with a par value of $5.
This stock recently paid a $2.10 dividend, and the firm's earnings per share
have increased from $2.40 to $4.48 in the past 5 years. An equivalent amount
of growth in the dividend is expected.

Your required rates of return for these investments are 6 percent for the bond, 7
percent for the preferred stock, and 15 percent for the common stock. Using this
information, answer the following questions.
1. Calculate the value of each investment based on your required rate of return.
2. Which investment would you select? Why?
3. Assume Emerson Electric's managers expect an earnings downturn and a
resulting decrease in growth of 3 percent. How does this affect your answers to
parts 1 and 2?
4. What required rates of return would make you indifferent to all three options?

Explanation / Answer

a) Calculating the value of each investment : Calculating the value of the bond using excel sheet: According to the given information, Face value of the bond = $1000 Years to maturity = 10 Coupon rate = 7.625% ($1000)                    = $76.25 Required return = 6.0% Step1: Go to excel and click "insert" to insert the function. Step2: Select the "PV" function as we are finding the Present value of the bond in this case. Step3: Enter the values as Rate = 6.0% ; Nper = 10; PMT = -76.25 ; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "$1,119.60" Therefore, the value of the bond is $1,120. Calculating the value of the preferred stock: Current price of the stock = $39 Kp = D / P0 P0 = D / Kp      = $2.8125 / $39      = 7.21% Value of preferred stock (P0) = D / K                                               = $2.8125 / 0.07                                               = $40.18 Calculating the value of common stock: Earnings growth = ($4.48 / $2.40) ^ (1/5) - 1                          = 13.3% Payout ratio = $2.10 / $4.48                    = 46.88% Required return = K = 15% D1 = $2.10 (1.133)       = $2.38 P0 = D1 / (K - g)      = $2.38 / (0.15 - 0.133)     = $2.38 / 0.017     = $140 Therefore, the value of common stock is $140 b) The bond is selling at a premium. The preferred stock is selling less than the par value and the common stock is selling for more than the par value and less than the price of the stock.Given a risk nuetral investor, the investor would select the common stock as it has the most excess NPV to the investor over and above the market price. However, his choice is not appropriate if the investors risk tolerance is not high enough. c)Assumed value oif grwoth declines by 3% then price of common stock is $49.24 P0 = D1 / (K - g)      = $2.3163 / (0.15 - 0.103)      = $49.24 Calculating the value of common stock: D1 = EPS ( 1+g) * (1-Payout ratio)      = $4.48 (1 + 0.103) * (1 - 0.4688)      = $2.62 This would probably make the common stock an unattractive investment as the value to you is below the market price. However, the market price would probably change in reaction to the information. d) The required rate of return that would make one indifferent to all the three options is the one that sets the price of the security (to you) equal to its market value. Bond required return is 7.83% Rate set equal to the $986 is 7.83% Preferred required rate is 7.21% which is equal to the $39 P0 = D / Kp      = $2.8125 / $39      = 7.21% Common stock required return is 16.27% set equal to $80 a) Calculating the value of each investment : Calculating the value of the bond using excel sheet: According to the given information, Face value of the bond = $1000 Years to maturity = 10 Coupon rate = 7.625% ($1000)                    = $76.25 Required return = 6.0% According to the given information, Face value of the bond = $1000 Years to maturity = 10 Coupon rate = 7.625% ($1000)                    = $76.25 Required return = 6.0% Step1: Go to excel and click "insert" to insert the function. Step2: Select the "PV" function as we are finding the Present value of the bond in this case. Step3: Enter the values as Rate = 6.0% ; Nper = 10; PMT = -76.25 ; FV = -1000 Step4: Click "OK" to get the desired value. The value comes to "$1,119.60" Therefore, the value of the bond is $1,120. Calculating the value of the preferred stock: Current price of the stock = $39 Kp = D / P0 P0 = D / Kp      = $2.8125 / $39      = 7.21% Value of preferred stock (P0) = D / K                                               = $2.8125 / 0.07                                               = $40.18 Calculating the value of common stock: Earnings growth = ($4.48 / $2.40) ^ (1/5) - 1                          = 13.3% Payout ratio = $2.10 / $4.48                    = 46.88% Required return = K = 15% D1 = $2.10 (1.133)       = $2.38 P0 = D1 / (K - g)      = $2.38 / (0.15 - 0.133)     = $2.38 / 0.017     = $140 Therefore, the value of common stock is $140 b) The bond is selling at a premium. The preferred stock is selling less than the par value and the common stock is selling for more than the par value and less than the price of the stock.Given a risk nuetral investor, the investor would select the common stock as it has the most excess NPV to the investor over and above the market price. However, his choice is not appropriate if the investors risk tolerance is not high enough. c)Assumed value oif grwoth declines by 3% then price of common stock is $49.24 P0 = D1 / (K - g)      = $2.3163 / (0.15 - 0.103)      = $49.24 Calculating the value of common stock: D1 = EPS ( 1+g) * (1-Payout ratio)      = $4.48 (1 + 0.103) * (1 - 0.4688)      = $2.62 This would probably make the common stock an unattractive investment as the value to you is below the market price. However, the market price would probably change in reaction to the information. d) The required rate of return that would make one indifferent to all the three options is the one that sets the price of the security (to you) equal to its market value. Bond required return is 7.83% Rate set equal to the $986 is 7.83% Preferred required rate is 7.21% which is equal to the $39 P0 = D / Kp      = $2.8125 / $39      = 7.21% Common stock required return is 16.27% set equal to $80 Step4: Click "OK" to get the desired value. The value comes to "$1,119.60" Therefore, the value of the bond is $1,120. Calculating the value of the preferred stock: Current price of the stock = $39 Kp = D / P0 P0 = D / Kp      = $2.8125 / $39      = 7.21% Value of preferred stock (P0) = D / K                                               = $2.8125 / 0.07                                               = $40.18 Calculating the value of common stock: Earnings growth = ($4.48 / $2.40) ^ (1/5) - 1                          = 13.3% Payout ratio = $2.10 / $4.48                    = 46.88% Required return = K = 15% D1 = $2.10 (1.133)       = $2.38 P0 = D1 / (K - g)      = $2.38 / (0.15 - 0.133)     = $2.38 / 0.017     = $140 Therefore, the value of common stock is $140 b) The bond is selling at a premium. The preferred stock is selling less than the par value and the common stock is selling for more than the par value and less than the price of the stock.Given a risk nuetral investor, the investor would select the common stock as it has the most excess NPV to the investor over and above the market price. However, his choice is not appropriate if the investors risk tolerance is not high enough. c)Assumed value oif grwoth declines by 3% then price of common stock is $49.24 P0 = D1 / (K - g)      = $2.3163 / (0.15 - 0.103)      = $49.24 Calculating the value of common stock: D1 = EPS ( 1+g) * (1-Payout ratio)      = $4.48 (1 + 0.103) * (1 - 0.4688)      = $2.62 This would probably make the common stock an unattractive investment as the value to you is below the market price. However, the market price would probably change in reaction to the information. d) The required rate of return that would make one indifferent to all the three options is the one that sets the price of the security (to you) equal to its market value. Bond required return is 7.83% Rate set equal to the $986 is 7.83% Preferred required rate is 7.21% which is equal to the $39 P0 = D / Kp      = $2.8125 / $39      = 7.21% P0 = D / Kp      = $2.8125 / $39      = 7.21% Common stock required return is 16.27% set equal to $80

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