CFA Practice Question

There are 191 practice questions for this study session.

CFA Practice Question

XYZ Corp. recently issued some preferred shares with a fixed preferred rate of $1.32 per share. Further research reveals that XYZ's common shares have a beta of 1.3 at a time when the market risk premium is 5.2% above the risk-free rate of 3.2%. If the difference in the risk premium between XYZ's common and preferred shares is 2%, what would be a fair value for the preferred shares?
A. $15.71
B. $16.58
C. It cannot be determined with the given information.
Explanation: Step 1. Compute the cost of common equity. R = 3.2 + 1.3 x 5.2 = 9.96

Step 2. The risk premium for preferred shares is always lower than the common equity of the same issuer. Rpre = 9.96 - 2.0% = 7.96%

Step 3. Compute value. P = 1.32/0.0796 = $16.58

User Contributed Comments 14

User Comment
mcspaddj The say the MRP is 5.2% above the Rf rate of 3.2%. This means the MRP is really 8.4% and the answer should be $10.89.

It really irks me when questions aren't asked properly.
eb2568 Agreed mcspaddj, had I not missed that error I probably would have gotten the question wrong too. It is very poorly worded!
Smiley225 yes very misleading.
Kuki it says market risk premium is 5.2% which means Rm - Rf = 5.2%
They have given Rf as 3.2%
Therefore Return on Equity R(E) is Rf + B(Rm-Rf) = 9.96%
i dont see anything wrong here...

Note: Risk Premium will ALWAYS be above Risk free rate. Thats y its called premium....
AusPhD Yep, Kuki is correct. Sorry guys, it wasn't Analystnotes fault!
wink26 Oops... I added the 2% premium instead of subtracting it. PF shares always have a LOWER risk premium than CS shares!!
clarelau Why not use Rpre=3.2%+1.3(5.2%-2%)=7.36%?
then 1.32/7.36%=17.93...well I choose the closet..but I dont get it why not substract 2% from the premuim first
richmondo Because the risk premium for the preferred is compared to the risk premium for the stock - not the risk premium for the market.
boddunah you assume 5.2- 2 =3.2 which is equal to rfr. but 5.2 is market risk premium which is (Rm - RfR).to get it right calculate r first then subtract 2% from it.
arendb Preferreds rank senior to common equity in the event of default....therefore less risk.
gill15 Kuki.

I did the same mistake as the guys before you who made the comments.
It specifically says the market risk premium is 3.2% above the risk free rate. I thought the MRP was 8.4% as well. Thats 3.2% above the risk free rate.
gill15 swithc 3.2 to 5.2 in my comment above
GBolt93 I'm guessing they meant the market return is 5.2% above the risk free rate, in which case the MRP would then be 5.2%.
crusse9 Life would have been simpler if they simply omitted " above the risk free rate". The term market risk PREMIUM already implies this. Crappy wording
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