Western Auto Inc. pays a 1.77 preferred dividend every quarter ...

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Western Auto Inc. pays a 1.77 preferred dividend every quarter and will maintain this policy forever. What price should you pay for one share of preferred stock if you want an annual return of 9.25 on your investment?
 
  A) 66.54
  B) 70.54
  C) 74.54
  D) 76.54

Question 2

If we know the dividend stream, the future price of the stock, the future selling date of the stock, and the required return, we can price stocks just as we priced ________.
 
  A) annuities
  B) perpetuities
  C) bonds
  D) preferred stocks

[briseldagonzales]

Answer to Question 1

Answer: D
Explanation: D) We use the perpetuity formula to derive the answer. When computing a perpetuity, we have to make sure that both the payment and the discount rate represent the same period. In this problem, let us use 3 months as our period. Thus, we restate the annual required rate of 9.25 as a quarterly (or three-month) rate of = 2.3125 (or 0.023125). Applying the constant dividend model with infinite horizon and with the quarterly rate of return and a quarterly dividend of 1.77, we get: = 76.54. We can get the same answer using annual data. For example, the annual dividend is . Thus, price = = 76.54.

Answer to Question 2

Answer: C
Explanation: C) Stocks can be priced just like bonds because bonds also have an income stream and future price (principal) with a known selling date ( maturity date).

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Gracias!

[mohan]

Excellent