Freelancers.com, a publishing agency, has an issue of preferred stock outstanding. The preferred stock of Freelancers pays a semiannual dividend of $0.40, and this dividend is not expected to grow in the foreseeable future. Similar investments are currently warranting a 12.5% per year required rate of return.
What is the value of Freelancers' preferred stock? Further, is this preferred stock valued as a perpetuity or as a finite series of cash flows?
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A. B. C. D. E. F.Explanation
Preferred stock is commonly valued as a perpetuity using the following equation: {P0 = [d1 / k]}
Where: P0 = the price of the preferred stock at time 0, d1 = the annual dividend at t1, and k = the required rate of return.
In this example, the dividend is provided as a semiannual figure, which must be doubled to show the annual dividend. After this adjustment has been made, the value of the preferred stock can be found as follows:
{P0 = [$0.80 / 0.125] = $6.40}
Preferred stock is commonly valued as a perpetuity because there is no finite conclusion to the projected series of cash flows for a preferred stock. Unlike a bond, whose cash flows are characterized by a finite lifespan (i.e. the cash flows of a bond cease at maturity), the cash flows (dividends) produced by a preferred stock could theoretically last forever.