Preferred Stock Valuation

There is no text book for this course!!

This is a preferred stock question. I need help with part b.

A share of preferred stock of MXT Ltd. is expected to pay $1.5 per quarter into indefinite future. The current annual expected rate of return (k) is 12%. Suppose that an investor buys 10 shares today and holds them for two years. Find his/her cash flows on a timeline in each of the following situations:

a. Interest Rates don't change

b. The required annual expected ROR on the preferred stock becomes 8% by the end of year 2.

Preferred Stock Valuation

I'll take a shot at this, but I'm not 100% positive...

The cash flows for the next two years aren't in question. They're $15 per qtr (= $1.50 per quarter * ten shares). The only question is how to determine what cash flow will occur at the end of the second year when the 10 shares of stock are sold. (I'm not sure given the question whether the end of year 2 preferred stock dividend is given to the seller or buyer, so you'll have to determine that.) But here's how I'd estimate the selling price after two years:

This would be considered an annuity (since the payouts continue indefinitely) with quarterly payments of $15 (for the ten shares combined). If the required annual return is 8%, we need to determine the quarterly-compounded equivalent rate of return, which is calculable as

(1.08)^.25 - 1 = 1.94%.

The formula for the present value of an annuity is the payout / interest rate, so we would get $15 / 1.94% = $772.14. This is the present value of what quarterly payouts of $15 is worth today, so this is the cash flow I believe could be expected for this annuity at that time.

So you've got $15 per quarter for the first two years, $772.14 after 2 years, and you'll need to determine what happens to the dividend at the two year mark.

- Steve J