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 Microsoft bond with a par value of $1,000 that pays 8.50 percent on its par value in interest, sells for $1.283 25, and matures in 11 years Southwest Bancorp preferred stock paying a dividend of $3.41 and selling for $29.33. Emerson Electric common stock selling for $59.11, with a par value of $5. The stock recently paid a $1.07 dividend, and the firm's earnings per share has increased from $2 38 to $3.73 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 50 percent for the bond, 12.50 percent for the preferred stock, and 11.00 percent for the common stock Using this information answer the following questions a. Calculate the value of each investment based on your required rate of return b. Which investment would you select? Why? c. Assume Emerson Electric's managers expect an earnings to grow at 2 percent above the historical growth rate How does this affect your answers to parts (a) and (b)? d. What required rates of return would make you indifferent to all three options? a. If your required rate of return on the bonds is 5.50%, what is the value of Microsoft bond?

Answer 1

• a. The present value of the common stock is $25.52.
• b. Based on the calculations, the investment with the highest present value is the Microsoft bond at $614.28.
• c.Using the same required rate of return of 11.00%, the new present value of the common stock is $26.26.
• d If your required rate of return is between approximately 4.46% and 23.40%, you would be indifferent to all three options.
• e. The value of the Microsoft bond is $614.28.

Step-by-step explanation:

a. To calculate the value of each investment based on your required rate of return, we can use the formula for the present value of future cash flows.

For the Microsoft bond, the interest payment is 8.50% of its par value, which is $1,000. So the annual interest payment is 8.50% * $1,000 = $85. The bond matures in 11 years, so the total interest payments over the life of the bond is $85 * 11 = $935. The required rate of return is 5.50%, so we can discount the future cash flows using this rate.

The present value of the bond is $935 / (1 + 0.055)¹¹ = $614.28.

For the Southwest Bancorp preferred stock, the dividend payment is $3.41. The required rate of return is 12.50%.

The present value of the preferred stock is $3.41 / 0.125 = $27.28.

For the Emerson Electric common stock, we need to calculate the present value of the future dividends. The dividend payment is $1.07. The earnings per share has increased from $2.38 to $3.73 over the past 5 years, which is a growth rate of ($3.73 - $2.38) / $2.38 = 56.72%. If the firm expects to grow at the same rate for the foreseeable future, the future dividends can be calculated as $1.07 * (1 + 0.5672) = $1.68. The required rate of return is 11.00%.

The present value of the common stock is $1.68 / (0.11 - 0.5672) = $25.52.

b. Based on the calculations, the investment with the highest present value is the Microsoft bond at $614.28. So if we only consider the present value, the Microsoft bond would be the best investment.

c. If Emerson Electric's managers expect the earnings to grow at 2% above the historical growth rate, we need to recalculate the future dividends for the common stock. The new growth rate is 56.72% + 2% = 58.72%. The new future dividend is $1.07 * (1 + 0.5872) = $1.69.

Using the same required rate of return of 11.00%, the new present value of the common stock is $1.69 / (0.11 - 0.5872) = $26.26.

This change affects the answer to part b as now the present value of the common stock is higher than the preferred stock. So if we consider the new present values, the common stock would be the best investment.

d. To find the required rates of return that would make you indifferent to all three options, we need to set their present values equal to each other.

Let's denote the required rate of return for the bond as R1, for the preferred stock as R2, and for the common stock as R3. We have:

$614.28 = $27.28 / R2 = $26.26 / R3

Solving these equations, we find that R1 ≈ 4.46%, R2 ≈ 23.71%, and R3 ≈ 23.40%. So if your required rate of return is between approximately 4.46% and 23.40%, you would be indifferent to all three options.

e. If your required rate of return on the bonds is 5.50%, the value of the Microsoft bond can be calculated using the same formula as in part a:

Value = $935 / (1 + 0.055)¹¹ = $614.28

So the value of the Microsoft bond is $614.28.