A portfolio manager with Churn Brothers Brokerage is examining shares of a newly-issued perpetual preferred stock for possible investment. The preferred stock is expected to pay a quarterly dividend of $0.70, and the required rate of return is 12.50% per year. At what price would this preferred stock be fairly valued?
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A. B. C. D. E. F.F
Assuming that the quarterly dividend is to remain unchanged forever allows us to use the standard perpetuity model for preferred stock, which is illustrated as follows:
Value of preferred stock = (Annual dividend / required rate of return)
In this example, we are given the quarterly dividend, which must be annualized before it can be imputed into the perpetuity valuation equation.
So said, a quarterly dividend of $0.70 translates into a yearly dividend of $2.80. Incorporating this yearly dividend into the perpetuity valuation model will result in the following:
Value of preferred stock = {$2.80 / 0.125} = $22.40