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Basic Question 4 of 12
The preferred stock of the Wordsworth Institute pays a constant annual dividend of $3.00 and sells for $20.00. You believe the stock will sell for $12.00 in one year. You must, therefore, believe that the required return on the stock will be which of the following percentage points (lower/higher) in one year?
B. the stock will be 8.0%; higher.
C. the stock will be 10.0%; higher.
A. the stock will be 8.0%; lower.
B. the stock will be 8.0%; higher.
C. the stock will be 10.0%; higher.
User Contributed Comments 14
| User | Comment |
|---|---|
| cgeek | how to get this answer? why $20 for this year and $12 in one year |
| jamiejamie | first, solve for k at time t0 = 15% then, solve for k at time t1 = 25% you get these values using the preferred stock value (preferred stock value = dividend/k) then, you know that there is an INCREASE of 10% (25%-15%) Intuitively, you know that if you get the same dividend for a cheaper security price, then your K must have risen. |
| stefdunk | the 10% increase is not in the value of the stock, but in the rate of return you expect. You want a higher payout, so the value of the share will drop (preferred stocks and bonds: value drops if payout % rises) |
| katybo | D/K = 3/0.25 = 12 -> 0.25-0.15 = 10% |
| haarlemmer | Sine the dividend is constant, the answer is then (3/12)-(3/20)=10% |
| Done | think about it like it was a bond. since the price went down the yield should go up. That eliminates A and D, then do the math |
| faya | If 3/k=20 => k=15%; If 3/k=12 => k=25%. Therefore, to get 3/k=12, you need to increase k by 10% |
| cfahanoi | k increase => P reduce 3/12 - 3/20 = 10% |
| accounting | go for cfahanoi |
| VenkatB | jamiejamie - thanks for the explanation. |
| jansen1979 | t0: $ 20 = $ 3/x => x = 15% t1: $ 12 = $ 3/x => x = 25% Increase of 10% |
| bundy | 3/12 = 25 3/20 = 15 therefore 10% higher |
| loisliu88 | cost of preferred stock=D/r, r0= D/P0, r1= D/p1 |
| 2014 | Good work bundy |
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Learning Outcome Statements
calculate the value of a common stock using the Gordon growth model and explain the model's underlying assumptions;
calculate the value of non-callable fixed-rate perpetual preferred stock;
calculate and interpret the implied growth rate of dividends using the Gordon growth model and current stock price;
describe strengths and limitations of the Gordon growth model and justify its selection to value a company's common shares;
CFA® 2025 Level II Curriculum, Volume 3, Module 21.