NOTES FOR LONG EXAM 2 FINANCE

Chapter 5: Time Value of Money

1. Time Lines
- Shows the timing of cash flows
- Tick marks occur at the end of periods, so Time 0 is today; Time 1 is the end of the
first period (year, month, etc) or the beginning of the second period

2. Drawing Time Lines

- $100 lump sum due in 2 years

- 3-year $100 ordinary annuity

- Uneven cash flow stream

3. Future Value Lump Sum

- What is the future value (FV) of an initial $100 after 3 years, if I/YR = 4%?
 - Finding the FV of a cash flow or series of cash flows is called compounding
- FV can be solved by using the step-by-step, financial calculator, and spreadsheet
methods

- E.g. Year 1 = 104, Year 2 = 108, etc.

4. Solving for FV: The Step-by-Step and Formula Methods
- After 1 year: FV_1 = PV (1 + I) = $100 (1.04) = $104.00
- After 2 years: FV_2 = PV (1 + I)^2 = $100 (1.04)^2 = $108.16
- After 3 years: FV_3 = PV (1 + I)^3 = $100 (1.04)^3 = $112.49
- After N years (general case): FV_N = PV (1 + I)^N

5. Present Value Lump Sum

- What is the present value (PV) of $100 due in 3 years, if I/YR = 4%?
 a. Finding the PV of a cash flow or series of cash flows is called discounting (the
reverse of compounding)
b. The PV shows the value of cash flows in terms of today’s purchasing power

6. Solving for PV: The Formula Method

7. Solving for I: What annual interest rate would cause $100 to grow to $119.10 in 3
years?
- Solves the general FV equation for I/YR
- Hard to solve without a financial calculator or spreadsheet
 - Excel: =RATE(nper,pmt,pv,fv,type,guess)
- Mathematical Equation:

8. Solves for N: If sales grow at 10% per year, how long before sales double?
- Solves the general FV equation for N
- Hard to solve without a financial calculator or spreadsheet

- EXCEL =NPER (rate,pmt,pv,fv,type)

- Mathematical Equation:

a. You can use log

9. Rule of 72
- Rule of 72 is an approximate formula to determine the number of years it will take to
double the value of your investment
- Rule of 72
a. N = 72 / interest rate
10. Solve for N: If sales grow at 10% per year, how long before sales double?
- Solves the general FV equation for N
- Hard to solve without a financial calculator or spreadsheet

- EXCEL =NPER(rate,pmt,pv,fv,type)
- Mathematical Equation:

Output should be 7.2

11. Solving for N: Mathematical Equation

12. Compound Interest with Shorter Compounding Periods

- Banks frequently offer savings account that compound interest every month or
quarter
- More frequent compounding will generate higher interest income for the savers if the
Annual Percentage Rate is the same

13. Compound Interest with Shorter Compounding Periods

 - You invest $500 for seven (7) years to earn an annual interest rate of 8%, and the
investment is compounded semi-annually. What will be the future value of this
investment?
a. Semi-annually (6 months)

14. Compound Interest with Shorter Compounding Periods

- You have been put in charge of managing your firm’s cash position and noticed that
the Plaza National Bank of Portland, Oregon has recently decided to begin paying
interest compounded semi-annually instead of annually. If you deposit $1000 with
Plaza National Bank at an interest rate of 12%, what will your account balance be in
five (5) years?
 - Answer: 1,790.85

15. Compound Interest with Shorter Compounding Periods

- If you deposit $50,000 in an account that pays an annual interest rate of 10%
compounded monthly, what will your account balance be in 10 years?
a. Compounded monthly = 12 months

16. Lump Sum vs Annuity

- $100 lump sum due in 2 years

- 3-year $100 ordinary annuity

 27:24

17. What is the difference between an ordinary annuity and an annuity due?
- Ordinary Annuity

- Annuity Due

Chapter 5: Time Value of Money – Annuities Part 2

18. The Future Value of an Ordinary Annuity

- FV_n = FV of annuity at the end of the nth period

- PMT = annuity payment deposited or received at the end of each period
- i = interest rate per period
- n = number of periods for which annuity will last

19. Ordinary Annuities

- How much money will you accumulate by the end of year 10 if you deposit $3000
each for the next ten (10) years in a savings account that earns 5% per year?
- We can determine the answer by using the equation for computing the future value of
an ordinary annuity

20. Solving for PMT in an Ordinary Annuity

- Suppose you would like to have $25,000 saved 6 years from now to pay towards your
down payment on a new house. If you are going to make equal annual end-of-year
payments to an investment account that pays 7 per cent, how big do these annual
payments need to be?
21. The Present Value of an Ordinary Annuity
- The present value of an ordinary annuity measures the value today of a stream of cash
flows occurring in the future

- PMT = annuity payment deposited or received at the end of each period

- i = discount rate (or interest rate) on a per period basis
- n = number of periods for which the annuity will last
- Note, it is important that “n” and “i” match. If periods are expressed in terms of
number of monthly payments, the interest must be expressed in terms of the interest
rate per month

22. Present Value Annuity Problem

- What is the present value of an annuity of $10,000 to be received at the end of each
year for 10 years given a 10 percent discount rate?
23. Analyze
- A lump sum or one time payment today of $61,446 is equivalent to receiving $10,000
every year for 10 years given a 10 percent discount rate

24. Amortized Loans

- An amortized loan is a loan paid off in equal payments – consequently, the loan
payments are an annuity
- Examples: Home mortgage loans, Auto loans

25. Amortized Loans

- In an amortized loan,
a. The present value can be thought of as the amount borrowed,
b. n is the number of periods the loan lasts for
c. i is the interest rate per period
d. future value takes on zero because the loan will be paid after n periods, and
e. payment is the loan payment that is made

26. Amortized Loans

- Suppose you plan to get a $9000 loan from a furniture dealer at 18% annual interest
with annual interest payments that you will pay off in over five years. What will your
annual payments be on this loan?
 - Annual Payment: $2,878.00

27. The Loan Amortization Schedule

- We can observe the following from the table:
a. Size of each payment remains the same
b. However, interest payment declines each year as the amount owed declines and
more of the principal is repaid
28. Amortized Loans with Monthly Payments
- Many loans such as auto and home loans require monthly payments. This requires
converting n to number of months and computing the monthly interest rate
- Example: You have just found the perfect home. However, in order to buy it, you
will need to take out a $300,000, 30-year mortgage at an annual rate of 6 percent.
What will your monthly mortgage payments be?
 - Here annual interest rate = 0.06, number of years = 30, PV = $300,000
a. $300,000 = PMT
b. $300,000 = PMT (166.79)
c. $300,000 / 166.79 = $1798.67

PART 3

29. Determining the Outstanding Balance of a Loan (Sample Problem)

- Let’s say that exactly ten years ago you took out a $200,000, 30-year mortgage with
an annual interest rate of 9 percent and monthly payments of $1,609.25. But since
you took out that loan, interest rates have dropped. You now have the opportunity to
refinance your loan at an annual rate of 7 percent over 20 years. You need to know
 what the outstanding balance on your current loan is so you can take out a lower-
interest-rate loan and pay it off. If you just made the 120th payment and have 240
payments remaining, what’s your current loan balance?

30. Sample Problem

- Step 1:
a. We need to determine how much you still owe on your loan
b. We need to determine PRESENT VALUE of your remaining payments
- Step 2:
a. Given:
b. Initial Loan: $200,000
c. 30-year Loan
d. Interest rate of 9%
e. Monthly payments of $1,609.25
f. You have made 10 years worth of payments (120 months)
g. 30-year loan = 360 months less 120 months = 240 months remaining
- Step 3:
a. Using Present Value Annuity Formula to solve the remaining monthly payment

b. Where m = number of times corresponding

c. Annual interest = 9%, Number of years = 20, m = 12, and PMT = $1,069.25

31. Annuities Due

 - Annuity due is an annuity in which all the cash flows occur at the beginning of the
period. For example, rent payments on apartments are typically annuity due as rent is
paid at the beginning of the month

32. Annuities Due: Future Value

- Computation of future value of an annuity due requires compounding the cash flows
for one additional period, beyond an ordinary annuity

33. Annuities Due: Future Value

- Future value of 10-year ordinary annuity of $3,000 earning 5 percent to be $37,734
- What will be the future value if the deposits of $3,000 were made at the beginning of
the year i.e. the cash flows were annuity due?

34. Annuities Due: Present Value

- Since with annuity due, each cash flow is received one year earlier, its present value
will be discounted back for one less period
35. Annuities Due: Present Value
- Present value of 10-year ordinary annuity of $10,000 at a 10 percent discount rate to
be equal to $61,446
- What will be the present value if $10,000 is received at the beginning of each year i.e.
the cash flows were annuity due?

36. Annuities Due

- The examples illustrate that both the future value and the present value of an annuity
due are larger than that of an ordinary annuity because, in each case, all payments are
received or paid earlier

37. Perpetuity
- A perpetuity is an annuity that continues forever or has no maturity. For example, a
dividend stream on a share of preferred stock. There are two (2) basic types of
perpetuities:
a. Growing perpetuity in which cash flows grow at a constant rate, g, from period
to period
b. Level perpetuity in which the payments are constant rate from period to period
38. Present Value of a Level Perpetuity

- PV = the present value of a level perpetuity

- PMT = the constant dollar amount provided by the perpetuity
- i = the interest (or discount) rate per period

39. Present Value of a Level Perpetuity

- What is the present value of $600 perpetuity at 7% discount rate?

- PV = $600 / 0.07 = $8,571.43

40. Present Value of a Growing Perpetuity

- In growing perpetuities, the periodic cash flows grow at a constant rate each period
- The present value of a growing perpetuity can be calculated using a simple
mathematical equation

41. Present Value of a Growing Perpetuity

- PV = Present value of a growing perpetuity

- = Payment made at the end of the first period

- i = rate of interest used to discount the growing perpetuity’s cash flows
- g = the rate of growth in the payment of cash flows from period to period
42. The Present Value of a Growing Perpetuity
- What is the present value of a perpetuity stream of cash flows that pays $500 at the
end of year one but grows at a rate of 4% per year indefinitely? The rate of interest
used to discount the cash flows is 8%

- Answer: $12,500

43. Complex Cash Flow Streams

- The cash flows streams in the business world may not always involve one type of
cash flows. The cash flows may have a mixed pattern. For example, cash flow
amounts mixed in with annuities

44. Complex Cash Flow Streams

- In this case, we can find the present value of the project by summing up all the
individual cash flows by proceeding in four steps:
 a. Find the present value of individual cash flows in years 1, 2, and 3
b. Find the present value of ordinary annuity cash flow stream from years 4 through
10
c. Discount the present value of ordinary annuity (step 2) back three years to the
present
d. Add present values from step 1 and step 3

45. Sample Problem: Complex Cash Flow Streams

- What is the present value of cash flows of $300 at the end of years 1 through 5, a cash
flow of negative $600 at the end of year 6, and cash flows of $800 at the end of years
7-10 if the appropriate discount rate is 10%?

46. Step 2: Decide on a Solution Strategy

- This problem involves two annuities (years 1-5, years 7-10) and the single negative
cash flow in year 6
- The $300 annuity can be discounted directly to the present using equation 6-2b
- The $600 cash outflow can be discounted directly to the present using equation 5-2

47. Step 2: Decide on a Solution Strategy

- This problem involves two annuities (years 1-5, years 7-10) and the single negative
cash flow in year 6
 - The $300 annuity can be discounted directly to the present using equation 5-2

48. Step 2: Decide on a Solution Strategy

- The $800 annuity will have to be solved in two stages:
a. Determine the present value of ordinary annuity in four years
b. Discount the single cash flow (obtained from the previous step) back 6 years to
the present using equation 5-2

49. Step 3: Solve

- Using the Mathematical Formula
- (Step 1) PV of $300 ordinary annuity

19:21

50. F
51. F
52. F

Chapter 9: Bonds and Their Valuation

1. What is a bond?
 - A long-term debt instrument in which a borrower agrees to make payments of
principal and interest, on specific dates, to the holders of the bond

2. Bond Markets
- Primarily traded in the over-the-counter (OTC) market
- Most bonds are owned by and traded among large financial institutions
- The Wall Street Journal reports key developments in the Treasury, corporate, and
municipal markets

3. Key Features of a Bond

- Par value: face amount of the bound, which is paid at maturity (assume $1000)
- Coupon interest rate: stated interest rate (generally fixed) paid by the issuer. Multiply
by par value to get dollar payment of interest
a. Coupon Rate x Par Value = Coupon Interest
- Maturity date: years until the bond must be repaid
- Issue date: when the bond was issued
- Yield to maturity: rate of return earned on a bond held until maturity (also called the
“promised yield”)

4. Effect of a Call Provision

- Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the
investor)
- Bond investors require higher yields on bonds
- In many cases, callable bonds include a deferred call provision and a declining call
premium

5. What is a sinking fund?

- Provision to pay off a loan over its life rather than all at maturity
- Similar to amortization on a term loan
- Reduces risk to investor, shortens average maturity
- But not good for investors if rates decline after issuance
6. How are sinking funds executed?
- Call x% of the issue at par, for sinking fund purposes
a. Likely to be used if r_d is below the coupon rate and the bond sells at a premium
- Buy bonds in the open market
a. Likely to be used if r_d is above the coupon rate and the bond sells at a discount

7. Other Types (Features) of Bonds

- Convertible bond: may be exchanged for common stock of the firm, at the holder’s
option
- Warrant: long-term option to buy a stated number of shares of common stock at a
specified price
- Putable bond: allows holder to sell the bond back to the company prior to maturity
- Income bond: pays interest only when interest is earned by the firm
- Indexed bond: interest rate paid is based upon the rate of inflation

8. What is the opportunity cost of debt capital?

- The discount rate (r_i) is the opportunity cost of capital and is the rate that could be
earned on alternative investments of equal risk

9. What is the value of a 10-year, 10% annual coupon bond, if r_d = 10% with a Par
value of 1,000?
10. What’s the value of a 10-year bond outstanding with the same risk but a 13%
annual coupon rate?
- The annual coupon payment is $130. Since the risk is the same it has the same yield
to maturity as the previous bond (10%). This bond sells at a premium because the
coupon rate > the yield to maturity.

11. What’s the value of a 10-year bond outstanding with the same risk but a 7% annual
coupon rate?
- The annual coupon payment is $70. Since the risk is the same it has the same yield to
maturity as the previous bonds (10%). This bond sells at a discount because the
coupon rate < yield to maturity.
12. Changes in Bond Value over Time
- What would happen to the value of these three bonds if the required rate of return
remained at 10%?

13. Bond Values over Time

- At maturity, the value of any bond must equal its par value
- If r_d remains constant:
a. The value of a premium bond would decrease over time, until it reached $1000
b. The value of a discount bond would increase over time, until it reached $1000
c. The value of a par bond stays at $1000

14. What is the Yield To Maturity (YTM) on the following bond?

- 10-year; 9% annual coupon; $1000 par value; selling for $887
- Must find the r_d that solves this model:
 - Bond Value =
- YTM Approximation Formula:

15. Find YTM if the Bond Price is $1,134.20

- 10-year; 9% annual coupon; $1000 par value; selling for $1,134.20
- Solving for I/YR, the YTM of this bond is 7.08%. This bond sells at a premium,
because YTM < coupon rate
16. Definitions
- Current Yield (CY) = Annual Coupon Payment / Current Price
- Capital Gains Yield (CGY) = Change in Price / Beginning Price
- Expected Total Return = YTM = Expected CY + Expected CGY

17. An Example: Current and Capital Gains Yields

- Find the current yield and the capital gains yield for a 10-year, 9% annual coupon
bond that sells for $887, and has a face value of $1000

- YTM = Current Yield + Capital Gains Yield

- Could also find the expected price one year from now and divide the change in price
by the beginning price, which gives the same answer

18. What is price risk? Does a 1-year or 10-year bond have more price risk?
- Price risk is the concern that rising r_d will cause the value of a bond to fall

- The 10-year bond is more sensitive to interest rate changes, and hence has more price
risk

19. Illustrating Price Risk

20. What is reinvestment risk?
- Reinvestment risk is the concern that r_d will fall, and future CFs will have to be
reinvested at lower rates, hence reducing income
- Example: Suppose you just won $500,000 playing the lottery. You intend to invest the
money and live off the interest

21. Reinvestment Risk Example

- You may invest in either a 10-year bond or a series of ten 1-year bonds. Both 10-year
and 1-year bonds currently yield 10%
- If you choose the 1-year bond strategy:
a. After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But,
if 1-year rates fall to 3%, your annual income would fall to $15,000
- If you choose the 10-year bond strategy:
a. You can lock in a 10% interest rate, and $50,000 annual income for 10 years,
assuming the bond is not callable

22. Conclusions About Price Risk and Reinvestment Risk

 - CONCLUSION: Nothing is riskless!

23. Semiannual Bonds

24. What is the value of a 10-year, 10% semiannual coupon bond, if r_d = 13%?
- Multiply by years 2: N = 2 x 10 = 20
- Divide nominal rate by 2: I/YR = 13/2 = 6.5
- Divide annual coupon by 2: PMT = 100/2 = 50

25. Would you prefer to buy a 10-year, 10% annual coupon bond or a 10-year, 10%
seminanual coupon bond, all else equal?
- The semiannual bond’s effective rate is:

- Excel: =EFFECT (.10,2) = 10.25%

 - 10.25% > 10% (the annual bond’s effective rate), so you would prefer the semiannual
bond

26. If the proper price for this semiannual bond is $1,000, what would be the proper
price for the annual coupon bond?
- The semiannual bond has a 10.25% effective rate, so the annual bond should earn the
same EAR. At these prices, the annual and semiannual bonds are in the equilibrium

- Excel: =PV(.1025,10,100,1000)

27. A 10-year, 10% semiannual coupon bond selling for $1,135.90 can be called in 4
years for $1,050, what is its yield to call (YTC)?
- The bond’s yield to maturity is 8%. Solving for the YTC is identical to solving for
YTM, except the time to call is used for N and the call premium is FV

28. Yield to Call

- 3.568% represents the periodic semiannual yield to call

-
- The effective yield to call can be calculated
29. When is a call more likely to occur?
- In general, if a bond sells at a premium, then (1) coupon > r_d, so (2) a call is more
likely
- So, expect to earn:
a. YTC on premium bonds
b. YTM on par and discount bonds

30. Default Risk

- If an issuer defaults, investors receive less than the promised return. Therefore, the
expected return on corporate and municipal bonds is less than the promised return
- Influenced by the issuer’s financial strength and terms of the bond contract

31. Types of Bonds

- Mortgage bonds (bond issued with an asset, with an asset promised to the
bondholder)
- Debentures (bond that has no collateral or no mortgage or asset promised in case of
default; more risk)
- Subordinated debentures (the secondary of a debenture – the bond has no collateral or
promised asset but second priority after debenture)
- Investment-grade bonds (the good ones; the Ayala type of bond)
- Junk bonds (bonds that are low-rated; big chance that the company may not perform
or not pay you back)

32. Evaluating Default Risk: Bond Ratings

 - Bond ratings are designed to reflect the probability of a bond issue going into default

33. Factors Affecting Default Risk and Bond Ratings

- Financial Performance
a. Debt Ratio
b. TIE Ratio
c. Current Ratio
- Qualitative Factors: Bond Contract Terms
a. Secured vs unsecured debt
b. Senior vs subordinated debt
c. Guarantee and sinking fund provisions
d. Debt maturity

34. Other Factors Affecting Default Risk

- Miscellaneous Qualitative Factors
a. Earnings stability
b. Regulatory environment
c. Potential antitrust or product liabilities
d. Pension liabilities
e. Potential labor problems

35. Bankruptcy
- Two (2) main chapters of the Federal Bankruptcy Act:
a. Chapter 11, Reorganization
b. Chapter 7, Liquidation
- For large organizations, reorganization occurs more frequently than liquidation,
particularly in those instances where the business is worth more “alive than dead”
 36. Chapter 11 Bankruptcy
- If company can’t meet its obligations:
a. It files under Chapter 11 to stop creditors from foreclosing, taking assets, and
closing the business and it has 120 days to file a reorganization plan
b. Court appoints a “trustee” to supervise reorganization
c. Management usually stays in control
- Company must demonstrate in its reorganization plan that it is “worth more alive than
dead”
a. If not, judge will order liquidation under Chapter 7

37. Priority of Claims in Liquidation

- Secured creditors from sales of secured assets
- Trustee’s costs
- Wages, subject to limits
- Taxes
- Unfunded pension liabilities
- Unsecured creditors
- Preferred stock
- Common stock

38. Reorganization
- In liquidation, unsecured creditors generally receive nothing. This makes them more
willing to participate in reorganization even though their claims are greatly scaled
back
- Various groups of creditors vote on the reorganization plan. If both the majority of
the creditors and the judge approve, the company “emerges” from bankruptcy with
lower debts, reduced interest charges, and a chance for success

Stocks Lecture
1. Stocks and their Valuation
 - Features of Common Stock
- Intrinsic Value and Stock Price
- Determining Common Stock Values
a. Discounted Dividend Model
b. Corporate Valuation Model
c. Other Approaches
- Preferred Stock

2. Facts about Common Stocks

- Represents ownership
- Ownership implies control
- Stockholders elect directors
- Directors elect management
- Management’s goal: Maximize the stock price

3. Intrinsic Value and Stock Price

- Outside investors, corporate insiders, and analysts use a variety of approaches to
estimate a stock’s intrinsic value (P_0)
- In equilibrium we assume that a stock’s price equals its intrinsic value
a. Outsiders estimate intrinsic value to help determine which stocks are attractive to
buy and/or sell
b. Stocks with a price below (above) its intrinsic value are undervalued (overvalued)

4. Determinants of Intrinsic Value and Stock Prices

5. Different Approaches for Estimating the Intrinsic Value of a Common Stock
- Discounted dividend model
- Corporate valuation model
- P/E multiple approach
- EVA approach

6. Discounted Dividend Model

- Value of a stock is the present value of the future dividends expected to be generated
by the stock

7. Constant Growth Stock

- A stock whose dividends are expected to grow forever at a constant rate, g
 - If g is constant, the discounted dividend formula converges to:

- r_s = rate of return

8. What happens if g> r_s?

- If g > r_s, the constant growth formula leads to a negative stock price, which does not
make sense
- The constant growth model can only be used if:
a. r_s > g
b. g is expected to be constant forever

9. Use the SML to Calculate the Required Rate of Return (r_s)

- r_rf = risk-free
- r_m = market return
- b = beta

10. Find the Expected Dividend Stream for the Next 3 Years and their PVs
11. What is the stock’s intrinsic value?
- Using the constant growth model:

12. What is the stock’s expected value, one year from now?
- D_1 will have been paid out already. So, expected P_1 is the present value (as of
Year 1) of D_2, D_3, D_4, etc

- Could also find expected P_1 as:

13. Find Expected Dividend Yield, Capital Gains Yield, and Total Return During First
Year
- Dividend yield
 - Capital gains yield

- Total return (r_s)

14. What would the expected price today be, if g = 0?

- The dividend stream would be a perpetuity

15. Supernormal Growth: What if g = 30% for 3 years before achieving long-run
growth of 6%?
- Can no longer use just the constant growth model to find stock value
- However, the growth does become constant after 3 years

16. Valuing Common Stock with Nonconstant Growth

17. Find Expected Dividend with Capital Gains Yields During the First and Fourth
Years
- Dividend yield (first year)
= D_1 / P_0 = $2.60 / $54.11 = 4.81%
- Capital gains yield (first year)
= Total Return – Dividend Yield (this is from the equation Total Return = Dividend
Yield + Capital Gain = 13.00% - 4.81% = 8.19%
- During nonconstant growth, dividend yield and capital gains yield are not constant,
and capital gains yield =/= g
- After t = 3, the stock has constant growth and dividend yield = 7%, while capital
gains yield = 6%

18. Nonconstant Growth: What if g = 0% for 3 years before long-run growth of 6%?
- D_0 = $2.00
19. Find Expected Dividend Yield and Capital Gains Yields During the First and
Fourth Years
- Dividend yield (first year)
= $2.00 / $25.72 = 7.78%
- Capital gains yield (first year)
= 13.00% - 7.78% = 5.22%
- After t = 3, the stock has constant growth and dividend yield = 7%, while capital
gains yield = 6%

20. If the stock was expected to have negative growth (g = -6%), would anyone buy the
stock, and what is its value?
- Yes. Even though the dividends are declining, the stock is still producing cash flows
and therefore has positive value

- g = 100% - 6% = 94% or 0.94

21. Find Expected Annual Dividend and Capital Gains Yields

- Capital gains yield
 = g = - 6.00%
- Dividend yield
= 13.00% -(- 6.00%) = 19.00%
- Since the stock is experiencing constant growth, dividend yield and capital gains
yield are constant. Dividend yield is sufficiently large (19%) to offset negative capital
gains

22. Preferred Stock

- Hybrid security
- Like bonds, preferred stockholders receive a fixed dividend that must be paid before
dividends are paid to common stockholders
- However, companies can omit preferred dividend payments without fear of pushing
the firm into bankruptcy

23. If preferred stock with an annual dividend of $5 sells for $50, what is the preferred
stock’s expected return?