Preferred stock question. I need help with part b.
A share of preferred stock of MXT Ltd. is expected to pay $1.5 per quarter into indefinite future. The current annual expected rate of return (k) is 12%. Suppose that an investor buys 10 shares today and holds them for two years. Find his/her cash flows on a timeline in each of the following situations:
a. Interest Rates don't change
b. The required annual expected ROR on the preferred stock becomes 8% bu the end of year 2.
To find the cash flows on a timeline in each of the situations, we need to calculate the cash flows for each year over the two-year holding period.
a. In the case where interest rates don't change, the cash flow per quarter for each share is $1.5. There are four quarters in a year, so the annual cash flow per share would be $1.5 * 4 = $6.
Since the investor has 10 shares, the total annual cash flow in each year would be $6 * 10 = $60.
So, the cash flows on the timeline for each year in situation (a) would be:
Year 1: $60
Year 2: $60
b. In the case where the required annual expected rate of return (ROR) on the preferred stock becomes 8% by the end of year 2, we need to calculate the present value of the cash flows at the new required ROR.
First, let's calculate the present value factor using the formula:
Present value factor = 1 / (1 + ROR)^n
where ROR is the required annual expected rate of return and n is the number of years.
For year 1, the present value factor would be:
Present value factor for year 1 = 1 / (1 + 0.12)^1 = 0.8929
For year 2, the present value factor would be:
Present value factor for year 2 = 1 / (1 + 0.08)^2 = 0.8573
Now, let's calculate the present value of the cash flows for each year:
Year 1 cash flow: $6 * 10 = $60
Present value of year 1 cash flow = $60 * 0.8929 = $53.57
Year 2 cash flow: $6 * 10 = $60
Present value of year 2 cash flow = $60 * 0.8573 = $51.44
The cash flows on the timeline for each year in situation (b) would be:
Year 1: $53.57
Year 2: $51.44
This calculation accounts for the change in required ROR on the preferred stock at the end of year 2.