CASE 2

1. Calculate the value of each investment based on your

required rate of return.
Sol.

Bonds; A debt investment in which an investor loans money to an entity

(corporate or governmental) that borrows the funds for a defined period of
time at a fixed interest rate. Bonds are used by companies, municipalities,
states and U.S. and foreign governments to finance a variety of projects
and activities.
A) PV= $1000
PMT= 63.5
N= 5
R=5%
FV= $ -1058.45
B) Preferred share; A class of ownership in a corporation that has a
higher claim on the assets and earnings than common stock. Preferred
stock generally has a dividend that must be paid out before dividends to
common stockholders and the shares usually do not have voting rights.
V (ps) = D = 2.63 = $32.875 (ECONOMIC VALUE OF SHARE)
I/Y

0.08

C) Common Stock; A security that represents ownership in a

corporation. Holders of common stock exercise control by electing a board of
directors and voting on corporate policy. Common stockholders are on the
bottom of the priority ladder for ownership structure. In the event of
liquidation, common shareholders have rights to a company's assets only
after bondholders, preferred shareholders and other debtholders have been
paid in full.
D, = d. *(1 + g) = 1.7304

V (cs) = D, / (i/g g) = 1.7304/ (0.12 0.0815) = $44.94 (ECONOMIC

VALUE)

2.
why.

Select an investment you would prefer explaining

Investment in Bonds (Bank of Canada) and in preferred shares of Southwest

Company is more profitable than investing savings in common share of
Emerson Electric Company. Because the market value of common share is
$52. As per above calculation, economic value of same share is $ 44.94. So,
it is not worth to buy common share.
Economic value of preferred share is $32.87 where market value is
$26.25 which shows it is a profitable investment.
Estimate value of Bonds is $1,058. Which is also a profitable
investment where interest rate is 6.35% and its a government bank, so its
secured.

3. Assume Emerson Electrics managers expect the

earnings to grow at 1% above the historical growth. How
does this affect your answers in (1) and (2)?
Growth = 8.15 + 1 = 9.15
In common share V(cs) = 1.60* (1 + 0.0915) / (0.12 0.0915) = $61.26
Now, the value of common shares is $61.26 (economic value). So, we can
invest in common share because it is also now profitable.

4. Explain the potential risk(s) you are exposed to for

each of the three alternatives?
Potential risk involved in Bonds is less because it is a secure investment in a
government bank.
b) In terms of South west Bancorp preferred shares the risk involves is higher
than bonds because there is always an uncertainty remain in share market.
C) Risk involved in common share is more because of the lower dividend rate
and its share market. So, it is uncertain and risk involved.