Preferred stock is a unique type of equity and is referred to as a hybrid security—it has characteristics of both bonds and common stock. In practice, preferred stocks are valued more like bonds, with market interest rates and investment quality playing major roles. For those investors interested in preferred stock investing, it is likely that interest rates play a key role in their investment strategies. The main strategies involve either seeking high levels of dividend income or taking advantage of falling market interest rates resulting in capital gains. Create a spreadsheet to model and answer the following questions related to preferred stock investments.

Questions

a. The Scully Corporation issued preferred stock with a stated dividend of 8% of par. Preferred stock of this type currently yields 7% with a par value of \($75.\) Assume that the firm has 800,000 shares of the preferred stock outstanding at this time and that the dividends (which qualify for the preferential tax rates) are paid annually. Reviewing its income statement, the EBIT is \($85\) million and it has annual interest payments of \($3\) million. The firm is in the 30% federal tax bracket.

1. What is the value of Scully’s preferred stock?

2. What is the fixed charge coverage of Scully preferred stock?

b. A group of speculators are interested in the Scully preferred stock because the current market interest rates are quite volatile. These speculators hope to gain from the poten movement in market rates. The group believes that the future course of rates will follow a downward trend, which should translate into an increase in their equity value.

1. Given the information about Scully preferred stock and your valuation calculations from question a, what will be the realized holding period return on this investment if the market yield on the preferred stock drops to 5% after 1 year?

2. What will be the realized holding period return on this investment if the market yield on the preferred stock rises to 8% after 1 year?