Question

North Pole Cruise Lines issued preferred stock many years ago. It carries a fixed dividend of $9 per share. With the passage of time, yields have soared from the original 10 percent to 7 percent (yield is the same as required rate of return).

a. What was the original issue price? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the current value of this preferred stock? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. If the yield on the Standard & Poor’s Preferred Stock Index declines, how will the price of the preferred stock be affected?

The price of preferred stock will increase.

The price of preferred stock will decrease.

Answer 1

Yield of a preferred stock = Annual dividend/Price of Preferred Stock

a) Original Issue price

Yield at issuance 10%, annual dividend = $9

10% = 9/Price of Preferred Stock

Price of preferred Stock = 9/10% = $90

b) Current Value of preferred stock

Yield = 7%, preferred dividend = $9

7% = 9/Price of Preferred Stock

Price of preferred Stock = 9/7% = $128.57

c) If the yield on the Standard & Poor’s Preferred Stock Index declines, how will the price of the preferred stock be affected - The price of preferred stock will increase

Preferred stock is like a fixed income security where price of the preferred stock is inversely related to the yield or required return on that security. This is also evident from the mathematical relation or formula, that we used above.