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:

• Bank of America bonds with a par value of $1000, that pays a 6.35 percent on its par value in interest, sells for $1,020, and matures in 5 years.

• Southwest Bancorp preferred stock paying a dividend of $2.63 and selling for $26.25.

• Emerson Electric common stock selling for $52, with a par value of $5. The stock recently paid a $1.60 dividend and the firm’s earnings per share has increased from $2.23 to $3.30 in the past 5 years. The firm expects to grow at the same rate for the foreseeable future.

Your required rates of return for these investments are 5 percent for the bond, 8 percent for the preferred stock, and 12 percent for the common stock. Using this information, answer the following questions.

a. Calculate the value of each investment based on you required rates of return.

b. Which investment would you select? Why?

c. Assume Emmerson Electric’s managers expect earnings to grow at 1 percent above the historic growth rate. How does this affect your answers to (a) and (b)?

d. What required rates of return would make you indifferent to all three options?

Explanation / Answer

Answer:

1st option:

Future value = FVIF (10,000 for 5 years at 6.25%)

therefore we can also calculate using the formula

Bond value = Coupon amount = 63.5 every year and matured at $1020

therefore PVIF of 63.5* PVIF 5 years 5.00% = 274.92

and 1020 at .7835 = $800

therefore the value of the bond at the end of the year would be = 800+272.92 = $1072.92 is the present value of the bond

Investment no of shares = 10,000/26.25 =380.95 shares

dividend of 2.63 *381 shares = $1002

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