Question

RockTop Construction expects to pay a $1.10 dividend next year to its common stock holders. In each following year, common stock dividends will grow at 4%. RockTop pays its preferred shareholders a dividend of $2.25 every year. If common stock sells at $12.57 per share and preferred stock sells at $23.41 per share, what are the required returns on each type of stock? Why might an investor prefer preferred stock? Why might an investor prefer common stock?

Answer 1

Re = D1 / P0 + g

Where,

Re= Return on equity

D1= Expected dividend to be paid next year

P0 = Price of stock

g = growth rate

Re = 1.1 / 12.57 + 0.04

= 0.1275 or 12.75%

Rp = D1 / P0

Where,

Rp = return on preferrd stock'

D0 = Dividend to be paid next year

P0 = Price of stock

Rp = 2.25 / 23.41

= 0.096 or 9.61%

Investor might prefer preferrd stock because it promises fixed return wheather company earns profit or not, as compared to common stock which may or may not get a dividend.

Investor might prefer common stock because it offers higher return as compared to preferred stock and gets voting right in company's matters.