Question

10) ABC preferred stock is trading for $52 on the market and it pays an annual dividend of $4.20 per share. a) What is the expected rate of return on the stock? b) If your required rate of return is 9%, how much is this stock worth to you? c) Considering your required rate of return from part b, does this stock seem like a desirable investment? Explain why or why not.

Answer 1

a) Expected rate of return in the stock: 8.08%

b) Stock price at a required rate of return of 9%: $46.67

c) Not desirable since the stock is overpriced.

Explanation:

• The stock price can be found using dividend discount model (without growth).
• Formula:

(a) Given stock price = $52; Annual dividend = $4.20.

Therefore,

• Expected rate of return = Annual dividend ÷ Stock value = $4.20 ÷ $52 = 0.0808 or 8.08%
• This formula is simply same as the present value of perpetuity.

(b) Stock price = Annual dividend ÷ required rate of return = $4.20 ÷ 0.09 = $46.67

(c) The stock is not a desirable investment since the investor's required rate of return is 9% where as the expected rate of return of the stock is only 8.08%.

The stock is worth $46.67 to the investor where as it is trading at $52. Thus, the stock is currently overpriced.