a share of preferred stock of MXT LTD. is expected to pay 1.0 per quarter into indefinite future. the current required annual expected rate of return, k, is 8%. suppose that an investor buys 10 shares today and wants to hold these shares for the next 2 years. find his/her cash flows on a timeline in each of the following situations:
A. interest rates do not change
B. interest rates decline so that the required annual expected rate of return on the preferred stock becomes 6% by the end of year 2
To find the cash flows on a timeline for the given situations, we need to consider the dividends expected to be received by the investor over the next 2 years.
A. When interest rates do not change:
Since the investor buys 10 shares and each share pays $1.0 per quarter, the investor will receive $1.0 * 4 quarters = $4.0 per share annually.
Therefore, the total annual dividend received by the investor will be $4.0 * 10 shares = $40.0.
The cash flows on a timeline for this situation would be as follows:
Year 1: $40.0
Year 2: $40.0
B. When interest rates decline to 6% by the end of year 2:
To handle this situation, we need to determine the change in the value of the preferred stock due to the change in the required annual expected rate of return.
In the given situation, the investor will still receive $1.0 per quarter per share, but with a decreased required annual expected rate of return of 6%.
To calculate the value of the preferred stock at the end of year 2, we can use the Dividend Discount Model (DDM) formula:
Value of preferred stock = Dividend / Required annual expected rate of return
Value of preferred stock at the end of year 2 = $1.0 * 4 quarters / 6% = $16.67
Therefore, the cash flows on a timeline in this situation would be as follows:
Year 1: $40.0
Year 2: $40.0 + $16.67
Please note that the cash flow in Year 2 increases because the decreased required annual expected rate of return increases the value of the preferred stock.