Question

1. Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return? Explain.
2. The preferred stock of Dragons Inc. pays a $3 dividend. What is the value of the stock if your required rate of return is 10%?
3. Mosser Corporation, Inc. paid a $4 dividend last year. At a constant growth rate of 6%, what is the value of common stock if the investors require a 10% rate of return?

Answer 1

Q1) The T-bill's return does not depend on the state of the economy because it is redeemed at par regardless of the state of the economy.

T-bills do not provide a completely risk-free return because there is still inflation risk (little unexpected inflation likely to occur) and also risky in terms of reinvestment risk.T-bills are risk-free in default sense of the word.

Q2) value of preference share = dividend / cost of preference share

= 3 / 10

= $30

Q3) value of equity = dividend (1+growth rate) / cost of equity - growth rate

= 4 (1+0.06) / 0.10 - 0.06

= 4 (1.06) / 0.04

= 4.24 / 0.04

= $106