Preferred shares of Chinnok Electrical Co. have a par value of \$100 and a dividend rate of 8%. The current price is \$105. If the risk-free rate is 2.5%, what is the risk premium associated with these preferred shares?

Answer +

Correct Answer: 0.0512 or 5.12%

Explanation +

To calculate the risk premium associated with the preferred shares of Chinnok Electrical Co., follow these steps:

Step 1: Identify Key Variables

Par value of the preferred shares ($P$): \$100
Dividend rate ($D$): 8% of par value
Current price of the preferred shares ($P_0$): \$105
Risk-free rate ($R_f$): 2.5%

Step 2: Calculate the Dividend Payment

\[ D = \text{Dividend rate} \times \text{Par value} = 0.08 \times 100 = 8 \text{ dollars} \]

Step 3: Determine the Required Rate of Return ($K$)

The required rate of return is found using the preferred stock valuation formula:
\[ P_0 = \frac{D}{K} \Rightarrow K = \frac{D}{P_0} = \frac{8}{105} \approx 0.0762 \text{ or } 7.62\% \]

Step 4: Calculate the Risk Premium

\[ \text{Risk premium} = K - R_f = 0.0762 - 0.025 = 0.0512 \text{ or } 5.12\% \]

Final Answer

The risk premium associated with the preferred shares of Chinnok Electrical Co. is 5.12%.

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