Today is July 1, 2023.
Your son wants to invest in some stocks but he cannot decide on which stocks to invest in. he knows that you are the master of finance. XYZ Inc. has two different kinds of stock in the market: preferred stock and common stock.
Preferred stock: Pays $1 every quarter and the required rate of return on this stock is 10% per year with quarterly compounding.
Common stock: Has just distributed $1.2 and analysts think that for the next 2 years, the dividends of the company will grow at 50% per year and then for another two years they will grow at 25% per year. After 4 years of supernormal growth, it is expected that the growth rate of dividends will stabilize at 5% per year and will stay at that level forever.
The analysts also forecast that the required rate of return on common stock of the company will be 14% for the next three years due to high risk but it will decrease to 12% after three years and will stay at that level forever.
1. Calculate the price of the preferred stock today.
2. Calculate the price of the common stock today.
3. If the preferred stock sells for $42 per share and the common stock sells for $45 per share in the market today, determine which ones of these stocks your son should invest in and state why.
4. Assuming one year passed, calculate the price of common stock at t=1.
5. Given the price you calculated in part 4, calculate the dividend yield, capital gains yield, and total return on the common stock of the company.
