292 Part 3 Financial Assets
has a par value and a! xed dividend that must be paid before dividends can be
paid on the common stock. However, the directors can omit (or “pass”) the pre-
ferred dividend without throwing the company into bankruptcy. So although pre-
ferred stock calls for a! xed payment like bonds, skipping the payment will not
lead to bankruptcy.
As noted earlier, a preferred stock entitles its owners to regular,! xed dividend
payments. If the payments last forever, the issue is a perpetuity whose value, Vp, is
found as follows:9-9 VP!DP
___r
P
Vp is the value of the preferred stock, Dp is the preferred dividend, and rp is the
required rate of return on the preferred. Allied Food has no preferred outstanding,
but discussions about such an issue suggested that its preferred should pay a divi-
dend of $10 per year. If its required return was 10.3%, the preferred’s value would
be $97.09, found as follows:Vp! $10.00__0.103! $97.09
In equilibrium, the expected return, rˆP , must be equal to the required return, rp.
Thus, if we know the preferred’s current price and dividend, we can solve for the
expected rate of return as follows:9-9a rˆP!DP
___
VP
Some preferreds have a stated maturity, often 50 years. Assume that our
illustrative preferred matured in 50 years, paid a $10 annual dividend, and had a
required return of 8%. We could then! nd its price as follows: Enter N " 50, I/YR
" 8, PMT " 10, and FV " 100. Then press PV to! nd the price, Vp " $124.47. If rp
rose to 10%, change I/YR to 10, in which case Vp " PV " $100. If you know the
price of a share of preferred stock, you can solve for I/YR to! nd the expected rate
of return, rˆP.SELF^ TEST Explain the following statement: Preferred stock is a hybrid security.
Is the equation used to value preferred stock more like the one used to evalu-
ate a bond or the one used to evaluate a “normal” constant growth common
stock? Explain.Corporate decisions should be analyzed in terms of how alternative courses of action
are likely to a% ect a " rm’s value. However, it is necessary to know how stock prices
are established before attempting to measure how a given decision will a% ect a spe-
ci" c " rm’s value. This chapter discussed the rights and privileges of common stock-
holders, showed how stock values are determined, and explained how investors
estimate stocks’ intrinsic values and expected rates of return.T Y I N G I T A L L T O G E T H E R