Question

Debt: 65,000 bonds outstanding ($1,000 face or par value) with an 7% coupon, 15 years to maturity, selling for 106 percent of par; the bonds make semiannual payments. Common Stock: 700,000 shares outstanding, selling for $65 per share; the beta is 1.2. Preferred Stock: 80,000 shares outstanding ($100 par value), it pays a 10% dividend on par, and it is selling for $125 per share. Market: The expected return on the market portfolio is 10% , the risk-free rate is 2% and the tax rate is 26%.

What is the required rate of return on preferred stock and common stock?

Answer 1

Preferred Stock:

Number of shares outstanding = 80,000
Current Price = $125
Annual Dividend = 10%*$100 = $10

Required rate of return = Annual Dividend / Current Price
Required rate of return = $10 / $125
Required rate of return = 8%

Equity:

Risk free rate = 2%

Expected Market return = 10%

Beta = 1.2

Required rate of return = Risk-free Rate + Beta * (Expected Market Return – Risk free rate)
Required rate of return = 2% + 1.2 * (10% - 2%)
Required rate of return = 2% + 9.6%
Required rate of return = 11.6%