CFA Level IEquity InvestmentsMedium
A preferred stock pays a fixed annual dividend of $4.50 per share in perpetuity, with no expected growth. If investors require a 9% rate of return on this preferred stock, what is its intrinsic value?
- A$55.56
- B$40.50
- C$50.00
- D$45.00
Show answer & explanationAnswer & explanation
Correct answer: C. $50.00
For a non-growing perpetuity (zero-growth DDM), value = D / r = $4.50 / 0.09 = $50.00.
Why the other options are wrong
- A. Incorrect; this results from an incorrect required return assumption (e.g., 8.1%).
- B. Incorrect; this results from multiplying rather than dividing the dividend by the required return.
- D. Incorrect; this is simply 10 times the dividend rather than dividing by the 9% rate.
Zero-Growth DDM (Preferred Stock Valuation)
For preferred stock or any perpetuity with a constant, non-growing dividend, intrinsic value equals the dividend divided by the required rate of return: V = D / r.
- Applies when dividend growth rate is zero
- Formula is a special case of the Gordon Growth Model with g=0
- Commonly used for valuing perpetual preferred shares
Memory trick: No growth, just divide dividend by required return.