Question

(a) Company A has issued perpetual preferred stock with a par value of $100. The stock pays an annual dividend of $6 and its current price is $60.

(i) What is the dividend yield of Company A’s preferred stock?

(ii) What is the total return of holding Company A’s preferred stock for year 1?  

(b) Company B has just paid a dividend of $2.45 per share. The company will increase its dividend by 20% next year and then reduce its dividend growth rate by 5 percentage points per year in the second and third years, followed by a constant 5% growth every year thereafter. If your required rate of return is 11%, what is the maximum price that you would be willing to pay for this company’s shares?

Please list the calculation steps

Answer 1

a)Par value=100, Dividend =6, current price =60
i) Dividend yield = 6/60 = 0.1 or 10%
ii)Total return = (Dividend+ par value- curreny price)/ current price = (6+100-60)/60 = 0.76 or 76%
b) Dividend for 1 st year (D1) = 2.45 *(1+20%) = 2.94
For 2nd year and 3 rd year growth is 15% so D2 = D1*1.15= 3.38, D3= D2*1.15= 3.89(r =11%)
PV of high growth dividend for 3 years = D1/(1+r) + D2/(1+r)²+D3/(1+r)³= 8.236
Now g=5%
PV of stable growth after 3 years = D3/(r-g)*(1/(1+r)³) = 3.89/(0.11-0.05) * 1/1.11³ = 47.41
Total Price of share = 8.24+ 47.41 = $55.64/price(Maximum price of share)