- CFA Exams
- CFA Level I Exam
- Study Session 13. Equity Investments (2)
- Reading 41. Equity Valuation: Concepts and Basic Tools
- Subject 3. Preferred Stock Valuation
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 |