Western Auto Inc. pays a $1.77 preferred dividend every quarter and will maintain this policy forever. What price should you pay for one share of preferred stock if you want an annual return of 9.25% on your investment?
A) $66.54
B) $70.54
C) $74.54
D) $76.54
Answer: D
Explanation: D) We use the perpetuity formula to derive the answer. When computing a perpetuity, we have to make sure that both the payment and the discount rate represent the same period. In this problem, let us use 3 months as our period. Thus, we restate the annual required rate of 9.25% as a quarterly (or three-month) rate of = 2.3125% (or 0.023125). Applying the constant dividend model with infinite horizon and with the quarterly rate of return and a quarterly dividend of $1.77, we get: = $76.54. We can get the same answer using annual data. For example, the annual dividend is . Thus, price = = $76.54.
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