ABC Investment Advisors is considering investing in bonds and stock issued by Major Works Incorporated. As part of the decision process, ABC is estimating Major’s bond and stock values and expected returns. Given below is the information determined by their research:

A. The current market price of Major’s outstanding corporate bonds is 107% of their $1,000 par value. The bonds have an annual coupon rate of 6.4% and make coupon payments semiannually. The bonds mature in 15 years.

B. The current price of the firm’s preferred stock is $86.00 per share. The stock has a $100 par value and a 4.4% annual dividend rate (paid annually).

C. The current price of the firm’s common stock is $765.00 per share. Its next (upcoming) semiannual dividend will be D1 = $3.80 per share. Dividends are paid semiannually and are expected to grow at an annual rate of 4% into the foreseeable future. NOTE that $3.80 is the amount of the semiannual dividend. It does not need to be divided by two.

ABC Investment Advisors is basing its analysis on a required rate of return equal to 5% per year. Based on the information above, answer the following:

1. What is the value of the company’s corporate bonds? What is the expected return (yield-to-maturity) of these bonds?

2. Based on the value and expected return (#1), should the bonds be purchased? Why? Be sure to base your answer on BOTH the value and the expected return.

3. What is the value of the company’s preferred stock? What is the expected return of the preferred stock?

4. Based on the value and expected return (#3), should the preferred stock be purchased? Why? Be sure to base your answer on BOTH the value and the expected return.

5. What is the value of the company’s common stock? What is the expected return of the common stock?

6. Based on the value and expected return (#5), should the common stock be purchased? Why? Be sure to base your answer on BOTH the value and the expected return.

Problem #2

Refer to the information concerning Major Works Incorporated in problem #1. In discussions with the company’s CEO, you learn that a decision has been made to eliminate future dividends on the company’s common stock. This means that, since your estimate of the expected return of common equity was based on the Discounted Cash Flow Method and a forecast of future dividend payments, that estimate needs to be updated.

It will be necessary to recalculate the expected return on common stock using the Capital Asset Pricing Model (CAPM). Research shows you the following:

Risk free rate Rf 2.5% per year (T-bill proxy)

Expected market return E(RM) 4.75% per year (S&P 500 proxy).

Further, the beta for the company is: βABC +1.45. A. Use the CAPM to estimate the expected return on Major’s common stock. B. Based on the beta given above, how does Major’s common stock react to changes in the overall market? Is Major’s common stock more or less risky than the market overall? How do you know?