Question 1:

You are considering two investments.

- The first investment that you are analyzing is a preferred stock that sells for $1600 and pays an annual dividend of $160. Your required rate of return for this stock is 25 percent.

- The second investment is a common stock that paid last year a $45 dividend. The firms earnings per share have increased from $40 to $80 in 10 years to have an annual growth rate equal to 7% which also reflects the expected growth in dividends per share indefinitely. The stock is selling for $250, and you think an appropriate required rate of return for the stock is 20 percent.

(a) Estimate the value of the preferred stock and common stock using Dividend Discount Model. [4 marks]

(b) Which investment(s) would you recommend? Explain your answer. [3 marks]

(c) Explain the relationship between the price of a stock today and its growth rate, assuming a constant growth model. [1 mark]

(d) Due to COVID-19, you expect the annual growth rate to decrease to 3% in the first year, before growing indefinitely at 5%. Evaluate the impact on the common stock. Clearly show your workings. [2 marks]