Question

Companies that have preferred stock outstanding promise to pay a stated dividend for an infinite period. Preferred stock is treated like a perpetuity if the payments last forever. Preferred stocks are considered to be a hybrid of a common stock and a bond. For example, one of the major differences between preferred shares and bonds is that the issuing companies can suspend the payment of their preferred dividends without throwing the company into bankruptcy.

However, similar to bonds, preferred stockholders receive a fixed payment—their dividend—before the company’s residual earnings are paid out to its common stockholders and, as with common stock, preferred stockholders can benefit from an appreciation in the value of the firm’s stock securities.

Consider the following case of Marston Manufacturing Company:

Marston Manufacturing Company pays an annual dividend rate of 11.00% on its preferred stock that currently returns 14.74% and has a par value of $100.00 per share. What is the value of Marston’s preferred stock?

$74.63 per share

$89.56 per share

$100.00 per share

$111.94 per share

Suppose that there is high unemployment, which causes interest rates to fall, which in turn pulls the preferred stock’s yield to 8.84%. The value of the preferred stock will _______ (increase/decrease).

Answer 1

Answer a.

Par Value = $100.00
Dividend Rate = 11.00%

Annual Dividend = Par Value * Dividend Rate
Annual Dividend = $100.00 * 11.00%
Annual Dividend = $11

Required Return = 14.74%

Value of Preferred Stock = Annual Dividend / Required Return
Value of Preferred Stock = $11 / 0.1474
Value of Preferred Stock = $74.63

Answer b.

Required Return = 8.84%

Value of Preferred Stock = Annual Dividend / Required Return
Value of Preferred Stock = $11 / 0.0884
Value of Preferred Stock = $124.43

Suppose that there is high unemployment, which causes interest rates to fall, which in turn pulls the preferred stock’s yield to 8.84%. The value of the preferred stock will increase.