CHAPTER 8

Valuation and Characteristics

of Stock
CHAPTER ORIENTATION
This chapter continues the introduction of concepts underlying asset valuation begun in
Chapter 7. We are specifically concerned with valuing preferred stock and common stock.
We also look at the concept of a stockholder’s expected rate of return on an investment.

CHAPTER OUTLINE
I. Preferred Stock
A. Features of preferred stock
1. Owners of preferred stock receive dividends instead of interest.
2. Most preferred stocks are perpetuities (non-maturing).
3. Multiple classes, each having different characteristics, can be issued.
4. Preferred stock has priority over common stock with regard to claims on
assets in the case of bankruptcy.
5. Most preferred stock carries a cumulative feature that requires all past
unpaid preferred stock dividends to be paid before any common stock
dividends are declared.
6. Preferred stock may contain other protective provisions.
7. Preferred stock contains provisions to convert to a predetermined
number of shares of common stock.
8. Retirement features for preferred stock are frequently included.
a. Callable preferred refers to a feature which allows preferred
stock to be called or retired, like a bond.
b. A sinking fund provision requires the firm periodically to set
aside an amount of money for the retirement of its preferred
stock.

252
 B. Valuation of preferred stock (Vps):
The value of a preferred stock equals the present value of all future dividends.
If the stock is nonmaturing, where dividends are expected in equal amount each
year in perpetuity, the value may be calculated as follows:
annual dividend D
Vps = =
required rate of return kps
II. Common Stock
A. Features of Common Stock
1. As owners of the corporation, common shareholders have the right to
the residual income and assets after bondholders and preferred
stockholders have been paid.
2. Common stock shareholders are generally the only security holders with
the right to elect the board of directors.
3. Preemptive rights entitle the common shareholder to maintain a
proportionate share of ownership in the firm.
4. Common stock shareholders’ liability as owners of the corporation is
limited to the amount of their investment.
5. Common stock’s value is equal to the present value of all future cash
flows expected to be received by the stockholder.
B. Valuing common stock
1. Dividend valuation model
a. Company growth occurs either by:
(1) The infusion of new capital.
(2) The retention of earnings, which we call internal growth.
The internal growth rate of a firm equals:
 Percentage of earnings 
Return on equity X retained within the firm
 
b. Although the bondholder and preferred stockholder are promised
a specific amount each year, the dividend for common stock is
based on the profitability of the firm and the management's
decision either to pay dividends or retain profits for
reinvestment.
c. The common dividend typically increases along with the growth
in corporate earnings.
d. The earnings growth of a firm should be reflected in a higher
price for the firm's stock.

253
 e. In finding the value of a common stock (Vcs), we should
discount all future expected dividends (Dl, D2, D3, D∞) to the
present at the required rate of return for the stockholder (kc).
That is:
D1 D2 D∞
Vcs = + +...+
(1 + k cs )
1
(1 + k cs ) 2
(1 + k cs )∞
f. If we assume that the amount of dividend is increasing by a
constant growth rate each year; that is, the dividend in year t, Dt,
equals:

Dt = D0 (l + g)t
where g = the growth rate
D0 = the most recent dividend payment
If the growth rate, g, is the same each year and is less than the
required rate of return, kcs, the valuation equation for common
stock can be reduced to
D1 D0 (1 + g)
Vcs = =
kcs - g kcs - g
2. Free cash flow valuation model

a. Free cash flow valuation defines the value of the firm to be the
present value of its expected future cash flows. More value is
equal to the present value of its “free cash flows” discounted at
the company’s cost of capital.

b. We compute the present value of the firm’s free cash flows as

the sum of the present values of the free cash flows for a
“planning period” plus the present value of the cash flows
beyond the planning horizon (i.e., the residual value), i.e.,

Intrinsic or
Planning Period
Economic Value = Present value  Cash Flows 
 
of the Firm

Residual
+ Present value  Value 
 

c. The present value, PV, of the free cash flows (FCFt) for the
planning period (year one through year T) is computed as
follows:

254
 T
FCFt
PV = ∑ (1 + k)
t =1
t

d. The value of residual cash flows in year T, which begin in year

T+1 can be calculated as follows:

FCFT+1
RV =
T k -g

e. We assume that the residual cash flows will grow at a constant

rate, g (which must be less than k) forever.
f. We then find the present value of the residual value as follows:

RVT
RV0 =
(1 + k)T

g. Then the present value, PV, of the combined planning period

free cash flows and the residual cash flows can be expressed as
follows:
T
FCFt RVT
PV = ∑ (1 + k)
t =1
t
+
(1 + k) T

III. Shareholder's Expected Rate of Return

A. The shareholder's expected rate of return is of great interest to financial
mangers because it tells about the investor’s expectations.
B. Preferred stockholder's expected rate of return.
If we know the market price of a preferred stock and the amount of the
dividends to be received, the expected rate of return from the investment can be
determined as follows:
annual dividend
expected rate of return =
market price of the stock
or
D
k ps =
Pps

C. Common stockholder's expected rate of return

1. The expected rate of return for common stock can be calculated from
the valuation equations discussed earlier.

255
 2. Assuming that dividends are increasing at a constant annual growth rate
(g), we can show that the expected rate of return for common stock,
k cs is
dividend in year 1 growth
k cs =  market price  +  rate 
   
D1
= + g
Pcs
Since dividend ÷ price is the "dividend yield," the
dividend growth
Expected rate of return =  yield  +  rate 
   

ANSWERS TO
END-OF-CHAPTER QUESTIONS

8-1. Preferred stock is many times referred to as a hybrid security. This is because
preferred stock has many characteristics of both common stock and bonds. It has
characteristics of common stock: no fixed maturity date, the nonpayment of dividends
does not force bankruptcy, and the nondeductibility of dividends for tax purposes. But
it is like bonds because the dividends are fixed in amount like interest payments. From
the point of view of the preferred stock shareholder, this is not the most delightful
combination. On one hand, the dividends are limited as with bonds, but the security of
forced payment by the threat of bankruptcy is not there. Thus, from the point of view
of the investor, the worst features of common stock and bonds are combined.
8-2. To a certain extent, preferred stock dividends can be thought of as a liability. The
major difference between preferred dividends in arrears and normal liabilities is that
nonpayment of them cannot force the firm into bankruptcy. However, since the goal of
the firm is shareholder wealth maximization, which involves getting money to the
shareholders (dividends), preferred arrearages do provide an effective block for the
goal of the firm.
8-3. A cumulative feature requires all past unpaid preferred stock dividends be paid before
any common stock dividends are declared. A stockholder would like preferred stock to
have a cumulative dividend feature because without it there would be no reason why
preferred stock dividends would not be omitted or passed when common stock
dividends were passed. Since preferred stock does not have the dividend enforcement
power of interest from bonds, the cumulative feature is necessary to protect the rights
of preferred stockholders.

256
 Other protective features serve generally to allow for voting rights in the event of
nonpayment of dividends, or they restrict the payment of common stock dividend if
sinking-fund payments are not met or if the firm is in financial difficulty. In effect, the
protective features included with preferred stock are similar to the restrictive provisions
included with long-term debt.
8-4. Convertibility allows a preferred stockholder to convert or exchange preferred stock for
shares of common stock at a predetermined exchange rate. This option gives preferred
stockholders more freedom in investment decisions by allowing them to convert into
common stock at their discretion.
Preferred stock may be callable by the issuer so that in the event interest rates decline
and cheaper funding becomes available, then the stock may be called and new
securities may be issued at a lower cost. To agree to the call feature, the investor will
require a slightly higher rate of return.
8-5. Both values are based on future cash flows to be received by stockholders. Preferred
stock typically has a predetermined constant dividend. For common stock, the
dividend is based on profitability of the firm and on management’s decision to pay
dividends or to retain the profits for reinvestment purposes. Thus, the growth of future
dividends is a prime distinguishing feature of common stock.
8-6. The expected rate of return is the rate of return that may be expected from purchasing a
security at the prevailing market price. Thus, the expected rate of return is the rate that
equates future cash flows with the actual selling price of the security in the market.
8-7. The expected rate of return is the discount rate that equates the present value of future
expected cash flows with the value of the security.
8-8. The two types of return include dividend income and capital gains. The dividend
income for common stockholders differs from preferred stockholders, in that no
specified dividend amount is to be received. However, the common stockholders are
permitted to participate in the growth of the company. As a result of this growth, their
second source of return, that of price appreciation, results.

257
 SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

8-1.

A B

Annual dividend $4.50 $4.25

Market Price $35.00 $36.00

Expected return $4.50/$35=12.86% $4.25/$36 =11.81%

You would choose stock A, which has an expected rare of return greater than your
required rate of return—12.86 percent versus 12 percent. On the other hand, stock B’s
expected rate of return does not meet your required rate of return.

8-2. Growth rate = return on equity x retention rate

Thus:

growth rate
Retention rate =
return on equity

.07
= = .58 or 58%
.12

8-3. a. Growth rate = return on equity x retention rate

= .115 x 0.55 = 0.0633 or 6.335

Dividend
b. Expected rate of return = + growth rate
Selling Price

$3.25(1+ .0633)
= + 0.0633 = 01496 or 14.96%
$40

c. Since he stock has an expected rate of return of 14.96 percent, which is greater
than you 13-percent required rate of return, you should invest.

Last Year Dividend (1 + Growth Rate)

8-4. Value (Vcs) =
(Required Rate - Growth Rate)

$1 + growth rate
$32.50 =
.12 − growth rate

258
 Solving for the growth rate, g:

$32.50(0.12 –g) = $1 + g,

$3.90 - $32.50g = $1 + g

$2.90 = $33.50g

g = 0.0866 or 8.66%

dividend rate x par value

8-5. Value(Vps) =
required rate of return

.14 x $100
=
.12
$14
=
.12
= $116.67

8-6. Expected Rate of Return

Dividend $1.95
k ps = = = or .0463, or 4.63%
Selling Price $42.16

Dividend $3.40
8-7. a. Expected return = = = .085 = 8.5%
Price $40
b. Given your 8 percent required rate of return, the stock is worth $42.50 to you
Dividend $3.40
Value = = = $42.50
Required Rate of Return .08
Since the expected rate of return (8.5%) is greater than your required rate of
return (8%) or since the current market price, ($40) is less than $42.50, the stock
is undervalued and you should buy.

Dividend in Year 1 Price in Year 1

8-8. Value (Vcs) = +
(1 + Required Rate) (1 + Required Rate)

$6 P1
$50 = +
(1 + .15) (1 + .15)
Rearranging and solving for P1:
P1 = $50 (1.15) - $6
P1 = $51.50
The stock would have to increase $1.50 ($51.50 - $50) or 3 percent ($1.50/$50) to earn
a 15% rate of return.

259
 Expected rate Dividend in Year 1 growth
8-9. a. (k cs ) = + rate
of return Market Price
$2.00
k cs = + .10 = .1889
$22.50
k cs = 18.9%
$2.00
b. Vcs = = $28.57
.17 - .10
Yes, purchase the stock. The expected return is greater than your required rate
of return. Also, the stock is selling for only $22.50, while it is worth $28.57 to
you.

Last Year Dividend (1 + Growth Rate)

8-10. Value (Vcs) =
(Required Rate - Growth Rate)
$3.50(1 + .05)
Vcs =
.20 - .05
Vcs = $24.50

8-11. Growth rate = return on equity x retention rate

= (18%) (40%) = 7.2%

8-12. Expected Rate of Return k cs )

Last Year Dividend (1 + Growth Rate)
= + Growth Rate
Price
_ 2.94(1.095)
k cs = + 0.095 = 0.193
$32.84
_
k cs = 19.3%

Dividend in Year 1 Price in year 1

8-13. Value (Vcs) = +
(1 + Required Rate) (1 + Required Rate)
$1.85 $42.50
Vcs = +
(1.11) (1.11)
Vcs = $39.96

260
8-14. If the expected rate of return is represented by k cs :
Dividend in year 1 Price in year 1
Current Price = +
(1 + k cs ) (1 + k cs )
Dividend in Year 1 + Price in Year 1
k cs = - 1
Current Price
$2.84 + $48.00
k cs = - 1 = 0.1823
$43.00
k cs = 18.23%

Dividend $3.60
8-15. a. k ps = = = 10.91%
Price $33.00
Dividend $3.60
b. Value (Vps) = = = $36
Required Rate of Return 0.10
c. The investor's required rate of return (10 percent) is less than the expected rate
of return for the investment (10.91 percent). Also, the value of the stock to the
investor ($36) exceeds the existing market price ($33). So buy the stock.

Dividend in Year 1 Growth

8-16. a. Expected Rate of Return = + Rate
Market Price
$1.32(1.08)
= + 0.08 = 0.1407
$23.50
= 14.07%
Dividend in Year 1
b. Investor's Value =
Required Rate of Return - Growth Rate
$1.32(1.08)
=
0.105 - 0.08
= $57.02
c. Yes, the expected rate of return is greater than your required rate of return (14
percent versus 10.5 percent). Also, your value of the stock ($57.02) is larger
than the current market price ($23.50).

D 6
8-17. Vps = = = $50 per share
k ps .12

8-18. growth rate = return on equity x earnings retention rate

= .16% x .6 = 9.6% growth rate

261
8-19. (Note: The following solution has been completed using Excel, with the printed solution
being to the nearest dollar. Thus, you may find some rounding errors.)

Given the following assumptions:

Cost of Capital 10.0%

Most Recent Year's Sales $2,000
Debt $250
Operating Profit Margin 12.0%
Assets/Sales 40.0%
Tax Rate 40.0%
Sales Growth Rates
1-2 years 14.0%
3-5 years 9.0%
Year 6 and Beyond 3.0%

Years 1 2 3 4 5 6
Sales $2,280 $2,599 $2,833 $3,088 $3,366 $3,467
Operating Profits $274 $312 $340 $371 $404 $416
Taxes 109 125 136 148 162 166
Operating Profits After Taxes $164 $187 $204 $222 $242 $250
Investments 112 128 94 102 111 40
Free Cash Flows $52 $59 $110 $120 $131 $209

Present Value Free Cash Flows $47 $49 $83 $82 $81

Shareholder Value:
Present Value of All Cash Flows Years 1-5 $343
Residual Value Year 5 $2,989
Present Value Residual Value 1,856
Firm Value $2,199
Debt 250
Shareholder Value $1,949

Where the present value of all cash flows years 1-5 is the sum of the present value of the
individual cash flows for years one through five, and the residual value in year 5 is equal to:

Free Cash Flow Year 6/(cost of capital – year 6 growth rate)

= $209/(0.10 – 0.03) = $2,986

And the present value of the residual value = residual value in year 5/(1 + cost of capital)5
= $2,989/(1+0.10)5 = $1,856

262
 SOLUTION TO MINI CASE

1. Value of each investment based on your required rate of return:

Bond:

10 N
6 I/Y
76.25 PMT
1000 FV
CPT PV → ANSWER -1119.60

10
$76.25 $1,000
Vb = ∑ (1 + .06) t
+
(1 + .06)10
t =1

= $76.25(7.3601) + $1,000(.55839)

= $561.21 + $558.39

= $1,119.60
Preferred Stock:

∞ $2.8125
Vps = ∑
t =1 (1 + .06)
t

However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to

Dividend
Vps =
Required Rate of Return

$2.8125
=
.07

= $40.18
Common Stock:
Step 1: Estimate Growth Rate

263
 Company's earnings have increased from $2.40 to $4.48 in five years. What
annual compound growth rate would cause an investment to increase in five
years?
Growth Rate (g) = (4.48/2.40)^(1/5)-1
= 13.30%
Step 2: Solve for Value

∞ $2.10(1 + .133) t
Vcs = ∑
t =1 (1 + .15) t

If the percent growth rate (g) is assumed constant, the equation may be reduced
to

Dividend at Year End

Vcs =
Required Rate of Return - Growth Rate

D1
=
kcs - g

$2.10(1 + .133)
=
.15 − .133

2.3793
=
.017
= $139.96
2. Your Value Selling Price
Bond $1,119.61 $986.00
Preferred Stock 40.18 39.00
Common Stock 139.96 80.00
You would choose to invest in all the securities. They are all selling for a price lower
than the value of investment based on your required rate of return.
3. Common Stock:
Growth Rate (g) = 13.3% - 3% = 10.3%

Dividend at Year End

Vcs =
Required Rate of Return - Growth Rate

D1
=
kcs - g

264
 $2.10(1 + .103)
=
.15 − .103

2.3163
=
.047
= $49.28
Your Value Selling Price
Common Stock 49.28 80.00
You would prefer not to buy the Emerson Electric stock because its selling price is
higher than the investment based on your required rate of return.
4. Bond:
10
$76.25 $1,000
$986 = ∑
t =1 (1 + k b ) t
+
(1 + k b )10
10 N
986 +/- PV
76.25 PMT
1000 FV
CPT I/Y → ANSWER 7.83

Required Rate of Return = 7.83%

Preferred Stock:

Dividend
Vps =
Required Rate of Return

39 = $2.8125 / Required Rate of Return

2.8125
Required Rate of Return =
39
= 7.21%
Common Stock:

Dividend at Year End

Vcs =
Required Rate of Return - Growth Rate
$2.10(1 + .133)
80 =
k − .133
2.3793
k = + .133
80
= 16.27%

265
 ALTERNATIVE PROBLEMS WITH SOLUTIONS

ALTERNATIVE PROBLEMS

8-1A. (Preferred Stock Valuation) What is the value of a preferred stock where the dividend
rate is 16 percent on a $100 par value? The appropriate discount rate for a stock of this
risk level is 12 percent.
8-2A. (Preferred Stockholder Expected Return) Shewmaker’s preferred stock is selling for
$55.16 and pays $2.35 in dividends. What is your expected rate of return if you
purchase the security at the market price?
8-3A. (Preferred Stockholder Expected Return) You own 250 shares of McCormick
Resources’ preferred stock, which currently sells for $38.50 per share and pays annual
dividends of $3.25 per share.
a. What is your expected return?
b. If you require an 8 percent return, given the current price, should you sell or
buy more stock?
8-4A. (Common Stock Valuation) You intend to purchase Bama, Inc., common stock at
$52.75 per share, hold it one year, and sell after a dividend of $6.50 is paid. How much
will the stock price have to appreciate if your required rate of return is 16 percent?
8-5A. (Common Stockholder Expected Return) Blackburn & Smith’s common stock currently
sells for $23 per share. The company’s executives anticipate a constant growth rate of
10.5 percent and an end-of-year dividend of $2.50.
a. What is the expected rate of return if you buy the stock for $23?
b. If you require a 17 percent return, should you purchase the stock?
8-6A. (Common Stock Valuation) Gilliland Motor, Inc., paid a $3.75 dividend last year. At a
constant growth rate of 6 percent, what is the value of the common stock if the
investors require a 20 percent rate of return?
8-7A. (Measuring Growth) Given that a firm’s return on equity is 24 percent and
management plans to retain 60 percent of earnings for investment purposes, what will
be the firm’s growth rate?
8-8A. (Common Stockholder Expected Return) The common stock of Bouncy-Bob Moore
Co. is selling for $33.84. The stock recently paid dividends of $3 per share and has a
projected constant growth rate of 8.5 percent. If you purchase the stock at the market
price, what is your expected rate of return?
8-9A. (Common Stock Valuation) Honeybee common stock is expected to pay $1.85 in
dividends next year, and the market price is projected to be $40 by year end. If the
investor’s required rate of return is 12 percent, what is the current value of the stock?
8-10A. (Common Stock Expected Rate of Return) The market price for M. Simpson & Co.’s
common stock is $44. The price at the end of one year is expected to be $47, and
dividends for next year should be $2. What is the expected rate of return?

266
8-11A. (Preferred Stock Valuation) Gree’s 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 investor’s required rate of return is 10 percent, what is the value of the
stock for the investor?
c. Should the investor acquire the stock?
8-12A. (Common Stock Valuation) The common stock of KPD paid $1 in dividends last year.
Dividends are expected to grow at an 8 percent annual rate for an indefinite number of
years.
a. If KPD’s current market price is $25, what is the stock’s expected rate of
return?
b. If your required rate of return is 11 percent, what is the value of the stock for
you?
c. Should you make the investment?
8-13A. (Comprehensive Problem in Valuing Securities) 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 the 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 firm’s earnings per share have increased
from $4 to $8 in 10 years, which also reflects the expected growth in dividends per
share for the indefinite future. The stock is selling for $25, and you think a reasonable
required rate of return for the stock is 20 percent.
a. Calculate the value of each security based on your required rate of return.
b. Which investment(s) should you accept? Why?
c. 1. If your required rates of return changed to 14 percent for the bond, 16
percent for the preferred stock, and 18 percent for the common stock,
how would your answers change to parts (a) and (b)?
2. Assuming again that your required rate of return for the common stock
is 20 percent, but the anticipated constant growth rate changes to 12
percent, would your answers to parts (a) and (b) be different?

267
SOLUTIONS TO ALTERNATIVE PROBLEMS

.16 x $100
8-1A. Value(Vps) =
.12

$16
=
.12

= $133.33

8-2A. Expected Rate of Return

_ Dividend $2.35
k ps = Selling Price = $55.16 = 4.26%

Dividend $3.25
8-3A. a. Expected return = = = .0844 = 8.44%
Price $38.50

b. Given your 8 percent required rate of return, the stock is worth $40.62 to you

Dividend $3.25
Value = = = $40.625
Required Rate of Return .08

Since the expected rate of return (8.44%) is greater than your required rate of
return (8%) or since the current market price ($38.50) is less than $40.62, the
stock is undervalued and you should buy.

Dividend in Year 1 Price in Year 1

8-4A. Value ( Vcs) = +
(1 + Required Rate) (1 + Required Rate)

$6.50 P1
$52.75 = +
(1 + .16) (1 + .16)

Rearranging and solving for P1:

P1 = $52.75 (1.16) - $6.50

P1 = $54.69

The stock would have to increase $1.94 ($54.69 - $52.75) or 3.6 percent ($1.94/$52.75)
to earn a 16% rate of return.

268
 _ Dividend in Year 1 growth
Expected
8-5A. a. ( k cs) = + rate
rate of return Market Price

_ $2.50
k cs = $23.00 + .105 = .2137

_
k cs = 21.37%

$2.50
b. Vcs = = $38.46
.17 - .105

The expected rate of return exceeds your required rate of return, which means
that the value of the security to you is greater than the current market price.
Thus, you should buy the stock.

Last Year Dividend (1 + Growth Rate)

8-6A. Value (Vcs) =
(Required Rate - Growth Rate)

$3.75(1 + .06)
Vcs =
.20 - .06

Vcs = $28.39

8-7A. Growth rate = return on equity x retention rate

= (24%) (60%) = 14.4%

_
8-8A. Expected Rate of Return ( k cs) =

Last Year Dividend (1 + Growth Rate)

+ Growth Rate
Price

_ $3.00(1.085)
k cs = + 0.085 = 0.181 = 18.1%
$33.84

Dividend in Year 1 Price in year 1

8-9A. Value (Vcs) = +
(1 + Required Rate) (1 + Required Rate)

$1.85 $40.00
Vcs = +
(1.12) (1.12)

Vcs = $37.37

269
 _
8-10A If the expected rate of return is represented by k cs:

Dividend in Year 1 PriceinYea r1

Current Price = +
(1 + k cs ) (1 + k cs )

Dividend in Year 1 + Price in Year 1

k cs = - 1
Current Price

$2.00 + $47.00
k cs = - 1 = 0.1136
$44.00

k cs = 11.36%

Dividend $4.00
8-11A. a. k ps = = = 11.43%
Price $35.00

Dividend $4.00
b. Value (Vps ) = = = $40
Required Rate of Return 0.10

c. The investor's required rate of return (10 percent) is less than the expected rate
of return for the investment (11.43 percent). Also, the value of the stock to the
investor ($40) exceeds the existing market price ($35). You should buy the
stock.

Dividend in Year 1 Growth

8-12A. a. Expected Rate of Return = + Rate
Market Price

$1.00(1.08)
= + 0.08 = 0.1232
$25.00

= 12.32%

Dividend in Year 1
b. Investor's Value =
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).

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8-13A. a. Value (Vb) based upon your required rate of return:

Bond:

12 $140 $1,000
Vb = ∑ (1 + .12) t
+
(1 + .12)12
t =1

= $140(6.194) + $1,000(.257)
= $867.16 + $257
= $1,124.16

Preferred Stock:
∞ $12
Vps = ∑
t = 1 (1 + .14)
t

However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to

Dividend
Vps =
Required Rate of Return
$12
=
.14
= $85.71

Common Stock:

Step 1: Estimate Growth Rate

Company's earnings have doubled ($4 to $8) in ten years. What annual
compound growth rate would cause an investment to double in ten years?
Looking in Appendix B (Compound sum of $1) an interest factor of 2.000 for
ten years is closest to seven percent (1.967). Thus, at about seven percent,
money would double in ten years. (The same conclusion could have been
reached by using Appendix D but by using a .500 present value interest factor.)

Growth Rate (g) = 7%

Step 2: Solve for Value

∞ $3(1 + .07)t
Vcs = ∑
t = 1 (1 + .20)
t

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 If the seven percent growth rate (g) is assumed constant, the equation may be
reduced to

Dividend at Year End

Vcs =
Required Rate of Return - Growth Rate

D1
=
kcs - g

$3(1 + .07)
=
.20 - .07

$3.21
=
.20 - .07

= $24.69
b. Your Value Selling Price
Bond $1,124.16 $1,200.00
Preferred Stock 85.71 80.00
Common Stock 24.69 25.00

Buy only the Preferred stock; it is the only investment in which the market
price is less than the value to you.

c. (1) Bond:
12 $140 $1000
Vb = ∑ (1 + .14) t
+
(1 + .14)12
t =1

= $140(5.660) + $1,000(.2076)

= $792.40 + $207.60

= $1,000.00

Still do not buy; it is not worth $1,200.00.

Preferred Stock:

$12
Vps =
.16

= $75.00

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 Do not buy. Your value is less than what you would have to pay for the
stock.

Common Stock:

$3.21
Vcs =
.18 - .07

= $29.18

Buy. Your value is greater than what you would have to pay for the
stock.

(2) Assuming a growth rate of 12 percent:

$3(1 + .12)
Vcs =
.20 - .12

$3.36
= = $42
.08

Buy. Because of the expected increase in future dividends, the stock is

now worth more to you ($42) than you would have to pay for it ($25)--
assuming that the selling price did not increase also.

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