You are considering three investments. The first is a bond that is selling in the market at RM1,200. The bond has an RM1,000 par value, pays interest at 14 per cent, and is scheduled to mature in 12 years. For bonds of this risk class, you believe that a 12 per cent rate of return should be required. The second investment that you are analyzing is a preferred stock (RM100 par value) that sells for RM80 and pays an annual dividend of RM12. Your required rate of return for this stock is 14 per cent. The last investment is a common stock (RM25 par value) that recently paid an RM3 dividend. The firm’s earnings per share have increased from RM4 to RM8 in 10 years, which also reflects the expected growth in dividends per share for the indefinite future. The stock is selling for RM25, and you think a reasonable required rate of return for the stock is 20 per cent.
(a) Calculate the value of each security based on your required rate of return.
(b) Which investment(s) should you accept? Why?
(c) If your required rate of return changed to 14 per cent for the bond, 16 per cent for the preferred stock, and 18 per cent for the common stock, how would your answer to (a) and (b) change?
(d) Assuming again your required rate of return for the common stock is 20 percent, but the anticipated constant growth rate changes to 12 percent, how would your answers to questions (a) and (b) change?