North Pole Cruise Lines issued preferred stock many years ago. It carries a fixe

Question

North Pole Cruise Lines issued preferred stock many years ago. It carries a fixed dividend of $8 per share. With the passage of time, yields have soared from the original 9 percent to 7 percent (yield is the same as required rate of return).
  
a. What was the original issue price? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
  

  
b. What is the current value of this preferred stock? (Do not round intermediate calculations. Round your answer to 2 decimal places.)
  

  
c. If the yield on the Standard & Poor’s Preferred Stock Index declines, how will the price of the preferred stock be affected?
  

Explanation / Answer

a. Preferred stock price = (dividend per share/ required rate of return on preferred stock)

Where,

Dividend per share = $8 per share

Preferred stock original issue price P0=?

Required rate of return on preferred stock = 9% (at the time of stock issue)

Therefore,

P0 = $8 / 9%

=$8/0.09 = $88.89 per share

Therefore Preferred stock price at the time of original issue was 88.89 per share

b. What is the current value of this preferred stock?

Now the current required rate of return on preferred stock is 7%; therefore

Current value of preferred stock = dividend / current required rate of return on preferred stock

= $8/7% = $8/0.07 = $114.29 per share

c. If the yield on the Standard & Poor’s Preferred Stock Index declines

The price of preferred stock will increase as yields decline. The preferred stock is a fixed income stock and its price is inversely related to its yields. The present value of an income stream will have a higher present value as the discount rate declines. Therefore price of preferred stock will increase.

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