Kathleen “Penni” Jock is a young career woman who has built up a substantial investment portfolio.
Most of her holdings are preferred stocks—a situation she does not want to change. Penni is now considering the purchase of $4,800 worth of LaRamie Corporation’s $5 preferred, which is currently trading at $48 a share. Penni’s stockbroker, Mr. Michaels, has told her that he feels the market yield on preferreds like LaRamie should drop to 7% within the next 3 years and that these preferreds would make a sound investment. Instead of buying the LaRamie preferred, Penni could choose an alternative investment (with comparable risk exposure) that she is confident can produce earnings of about 10% over each of the next 3 years.
Questions
a. If preferred yields behave as Penni’s stockbroker thinks they will, what will be the price of the LaRamie $5 preferred in 3 years?
b. What return will this investment offer over the 3-year holding period if all the expectations about it come true (particularly with regard to the price it is supposed to reach)? How much profit (in dollars) will Penni make from her investment?
c. Would you recommend that she buy the LaRamie preferred? Why?
d. What are the investment merits of this transaction? What are its risks?