1. You are considering two investment opportunities. The first one is a GM’s preferred stock which pays you an annual dividend of $36 (but on a quarterly basis) for 20 years, and at which time investors can redeem the preferred stock for $300 a share. The second choice is a 15-year GM bond that pays 3% coupon per year (on a semi-annual basis) and with a face value of $100. The preferred stock and the bond have beta risks of 0.9 and 0.25, respectively. The annual risk-free interest rate is 2% and the annual market risk premium is 8%. [hint: the rate you compute using the CAPM is in EAR]
(a) What should be the prices of the two securities? (b) If you are allowed to convert your GM bond into GM preferred stock at the end of the fifth year, what should be the term of conversion? (hint: it refers to the number of bond needed to get a share of preferred stock) (c) Comparing the prices over time for each security (see your answers in (a) and (b)), what pattern do you see?
