 personal finance practice problem using one note preferred stock current yield and price calculation prepare to get financially fit by practicing personal finance you're not required to but if you have access to one note would like to follow along we're in the icon left hand side practice problems tab in the 12 260 preferred stock current yield and price calculation tab also take a look at the immersive reader tool the practice problems typically in the text area too with the same name same number but with transcripts transcripts that can be translated into multiple languages and either listened to or read in them we're now thinking about investment in preferred stock which is a little bit different a little bit more unusual a bit more exotic than our other investments because usually we think about investments as two main categories either fixed income usually the bonds or the equities typically the common stock the preferred stock actually falls kind of somewhere in the middle technically it's on the equities side of things but functionally it acts more like a bonds type of investment which actually makes it a little bit easier to think about in some ways although it's far less common to invest in the preferred stock than in say the common stock because again normally we're either investing in say bonds for example or the common stock so the reason the preferred stock is kind of more on the equity side is because when you think about the corporation for example that say we're giving money to the corporation for a bond versus preferred stock if we're buying preferred stock from the company then they're going to be receiving cash and the other side is going to be in the equity section kind of like the common stock but now in the preferred stock section of the equity which represents basically the ownership interest of the assets of the corporation whereas if they were to distribute bonds if we bought bonds from a company they would get the cash and the other side would be a liability recorded in the liabilities section the reason preferred stocks are preferred is not because they're better than the common stocks but they have certain pros and cons related to the preferred stock the preferred component is typically that the payments for the preferred stock that dividends are more standard they're more set and usually they have to be paid before the common stock that's why the preferred they're going to be paid first they also have the benefit of if there was a default if the company went bankrupt then the preferred stockholders in theory get paid before the common stockholders when they pay out in accordance to the liquidation process however the bond holders get paid before the preferred stockholders so the preferred stock kind of acts more like a bond in that you're going to get these series of payments that are fairly guaranteed into the future although not as guaranteed as the bonds because if they don't pay the bonds then you actually default on the bonds and that's a big problem for the corporations but a fairly constant stream and certain stream of income into the future now remember with the bonds the fixed income side of things then you usually have the future cash flows that we're going to value the bonds for and that's going to be a series of interest payments like an annuity that we can discount and then we've got the maturity of the bond that we can discount to the present value the preferred stock is going to be a series of basically preferred dividends that will be kind of uniform going out into the future but there's no endpoint to them so they kind of go out indefinitely into the future we don't have the maturity date and we don't have that that lump sum amount at the point of maturity okay so given that we can try to value the preferred stock in a similar way that we can value the bonds and it's easier to do so than with the common stock because with the common stock we have a little bit more complexity because the dividends might vary more than they would with a preferred stock and because we also have the other kind of form of growth that we're going to have which would be the increase in the value of the stock price there's not so much fluctuation in the value of the preferred stock price it's going to act more kind of like a a bond because you're paying for the future stream of income in essence as opposed to paying for the increase in the value of the company as a whole represented by the common stock okay so we're going to say the par values 300 the yield at the time of issuance is 12 the current market price is 240 so the and the market rate is going to be 15 percent so if we're going to calculate the current yield we could say the annual dividend payment is going to be 300 dollars times the yield at the time of issuance which would probably be equal to the market rate at the point of issuance and possibly changing as time passes 12 percent that means it's going to be having an annual dividend payment of 300 times 12 percent or point one two of 36 if we take that and compare it to the current market price which we're going to say is the 240 so that's what they're trading for then 36 divided by 240 is the 15 percent so 36 divided by the 240 market price is the 15 percent current yield the yield remember is typically calculated on a yearly basis and that's the thing that we can use to compare to other types of investments of a similar type of nature to see which would be best now let's go ahead and try to calculate we're going to get back to this 240 calculating the price assuming that we have the current yield which we're going to say for example would be the market yield that we can get on other similar type of investments and let's say the annual dividend was the 36 dollars we can use our present value of future payments to get back to the 240 the market price in a similar way as the bonds remember on the bonds there's two cash flow streams that we looked at in the future one is the series of interest payments which is fixed and the other is the present value of the amount at maturity that we're going to be receiving kind of like the principle here all we have is a series of payments that is basically fixed into the future no maturity assuming they basically go on indefinitely because the corporation could live indefinitely so if i was the present value for example using the rate which would be the market rate the 15 percent because the 12 percent was used just to calculate what the payments would be and then comma the number of periods we don't know because it goes on forever so i'm just going to pick a large number because remember as you get further and further out into the future this dividend is going to be fairly small once we discount it back to the present value so i'm just going to pick like 100 here comma number of periods or the payment is going to be the 36 dollars and that's going to give us our 240 getting us back to that 240 let's try to map that out like we like we've seen with the bonds if i break it out on a year by year basis that we've seen up top year by year and we said for example 36 dollars if i discount the 36 dollars at the market rate 15 percent back one year it would get to the 31 dollars and 30 cents about so the rate here present value 15 percent number of periods one no payment because this is not an annuity comma comma therefore and the future values 36 so if i did that all the way across for year two for example 36 dollars discounted back two years at 15 percent 27 three years 36 dollars discounted 15 percent uh 23 and so on you can see it's going to get smaller and smaller all the way out and we when we get close to 100 way out into the future it's a very small number and that's why even though it's kind of indefinite it goes on forever we can basically we can we can value it even though there's no maturity date and if i was to add up that series of payments we get to the 31.30 uh the the 240 i'm sorry we get to the 240 that we calculated here so it's just and so notice this is actually a little bit easier in some ways than valuing the bond because we don't have that maturity lump sum at the end but it's a little bit more difficult at the same time because we don't have a maturity date this goes on you know indefinitely would be kind of the inception you could value this vertically doing the same kind of thing so if i take the periods from one down to 100 i highly recommend by the way doing these kind of estimates in excel because they allow you to visualize putting your table together this way they allow you to visualize putting your table together for this way this is easier to copy and paste this stuff vertically but the headers are a little bit more difficult if you had long titles for your headers you might have to use multiple cells or wrap this wrap the cells and then if we took our dividends at 36 and i present value them now i'm present valuing for example the rate would be once again the 15 percent number of periods is going to be one pulled from here this time no payment comma comma and the future value would be 36 taking that 36 discounting it back one year to 31 and if i did that all the way down this way it would be easier for me to copy the cells down this way typically and then i can then get and sum this up and get back to that 240 so again the preferred stock are actually a little bit easier in some ways to to calculate or estimate what's going to happen in the future than the common stock but the comments so they're kind of more like the fixed income but because they're kind of a hybrid type of thing they're somewhat in the middle between fixed income and the common stock most of the time we default to if i want fixed income i go to bonds if i want common if i want equity investment obviously i go to common stocks but oftentimes sometimes you might want something like this depending on the returns for it particularly if you're in a situation where you want to live off the income meaning you're in like retirement for example or something like that and you're looking for other types of investments that have a fixed return that you can basically be living on the return similar to dividends for the equity side of things or on the fixed income side of things similar to the bonds possibly finding some investments that might have a higher return than than maybe bonds depending on the circumstances