Alpha Corporation has outstanding an issue of preferred stock with a par value of $100. It pays an annual dividend equal to 8 percent of par value. If the required return on Alpha’s preferred stock is 6 percent, and if Alpha pays its next dividend in one year, what is the market price of the preferred stock today? Explain why the price would change, if the required rate increased to 10 percent.

Answer 1

Par value of preferred stock = $100
Annual dividend DP = 8% of $100 = $8
Required rate of return KP = 6%
Market price of preferred stock= DP / KP
= $8 / 0.06
= $133.33
Required rate of return KP = 10%
Market price of preferred stock= $8 / 0.10
= $80
There is inverse relationship between required rate of return and price, so when the required rate increased from 6% to 10%, price of the preferred stock decreased from $133 to $80.