Question

After scrimping and saving, you have $20,000 in your bank account. You are considering investing in MBC, Munchy Bites Company, which manufactures tasty snacks. You are offered the following three possible choices:

Choice 1: common stock in MBC with a current share price of P = 100. It pays an annual dividend of $10 per share and you expect the price of the stock to increase by 5% by the end of the year.

Choice 2: preferred stock in MBC with a current price P = 50 and pays an annual dividend of $X per share and you expect the price of the stock to increase by 0% by the end of the year.

Choice 3: a one year T Bill issued by MBC with an interest rate of 7%.

a. For choice 1, determine the expected return for the common stock MBC.

b. For choice 2, suppose that there are two possibilities for the annual dividend of X, 5 or 10. Determine which one the preferred stock offers. Defend your choice, and include the concept of residual claimant in your answer.

c. Now assume that you get an inside tip from Ben that interest rates are going to rise next year, and that they will announce this interest rate increase tomorrow. Comparing choice 1 and choice 3, which one will change the most in value in percentage terms?

Answer 1

a. Expected return for the common stock of MBC= [10+ (105-100)]/100 = .15 or 15%

b. When X = 5, the annual expected return is 10%. Preferred stocks are less risky because their priority claim is higher than common stock, so their return should be lower. Common stocks are more risky because they are the residual claimant and their priority claim is the lowest. In part (a) we calculated the return on the common stock to be 15%.

c.If we suppose that the interest rate rises by 1%,then the change in the value in percentage terms will be the highest for the financial instruments with longest maturity period. This is because of interest rate risk. Choice 1 will change more in percentage terms because it pays dividends into the future. Choice 3 is a short term debt instrument and hence has the lowest maturity period. Therefore change in its value will be less.