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Chapter 17: Problem 5

In what ways is preferred stock like long-term debt? In what ways is it like common stock?

Short Answer

Expert verified
Preferred stock is like long-term debt in the sense that both have fixed returns. However, the significant difference is that the dividend payment for preferred stock is not an obligation, unlike the interest payment for long-term debt. Preferred stock is like common stock in the sense that both are equities, representing ownership in a company. However, preferred stockholders have a higher claim on assets and income, and receive dividends before common stockholders, but usually do not have voting rights, unlike common stockholders.

Step by step solution

01

Understanding the Concepts

Start off by defining what preferred stock, common stock, and long-term debt are. Preferred stock is a type of equity (ownership in a company), with a higher claim on earnings and assets than common stock. Like long-term debt, preferred stock typically has a fixed dividend. Common stock is also a type of equity but has a lower claim on earnings and assets. It doesn't typically have a fixed dividend but has voting rights, unlike preferred stock.
02

Comparing Preferred Stock to Long-Term Debt

Now, focus on the similarities and differences between preferred stock and long-term debt. The similarity lies in that both have a fixed return. Preferred stocks pay a fixed dividend, and long-term debt involves fixed interest payments. The difference is in the nature of payment. While the dividend payment for preferred stocks can be omitted without the threat of bankruptcy, the interest payment for long-term debt is a legal obligation.
03

Comparing Preferred Stock to Common Stock

Finally, compare preferred stock with common stock. Both represent ownership in a company. However, preferred stockholders have a higher claim on the company鈥檚 assets and income, which means if the company went bankrupt, the preferred stockholders would be paid off before the common stockholders. Moreover, preferred stockholders receive dividends before they are distributed to common stockholders. However, unlike common stockholders, preferred stockholders typically do not have voting rights.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Preferred Stock
Preferred stock is a unique type of investment that sits somewhere between common stock and long-term debt. It represents ownership in a company, just like common stock. Yet, it is somewhat "safer," as it generally comes with a fixed dividend. This means that investors are promised a specific return on their investment each year. Preferred stock
  • offers no voting rights, which means you don鈥檛 have a say in the company鈥檚 big decisions,
  • but it provides you a higher claim on earnings and assets compared to common stock.
If the company does well or has leftover profits after paying preferred stockholders, common shareholders might get a share of the earnings.
However, if the company struggles, preferred stockholders are prioritized over common stockholders when dividends are paid.
Another important note is that while preferred dividends may be skipped in a financial crunch, missing long-term debt payments could lead to bankruptcy for the company.
Common Stock
Common stock is what most people think of when they hear the word "stocks." It represents true ownership in a company and comes with voting rights, which allows holders to influence the company by voting on certain decisions.
  • Common stockholders have the potential for higher rewards if the company performs well, as there鈥檚 no cap on dividend or price appreciation.
  • However, the risk is also higher because they are distant in the line to receive dividends and assets.
In the event of financial trouble, common shareholders are the last to be paid. That means if the company is liquidated, preferred stockholders and debt holders get priority. Though they carry more risk, the possibility of higher returns can be attractive to investors who believe in the company鈥檚 upside potential.
Long-Term Debt
Long-term debt is a vital component in many companies' financial structures. It refers to loans or financial obligations that are due in over a year. These can include bonds or mortgages that companies use to fund large projects or capital expenditures. The primary characteristics of long-term debt include:
  • Fixed interest payments, which can help companies plan their financial future more predictably.
  • Legal obligations to pay creditors as per schedule, making it riskier for companies to miss payments.
Unlike stocks, holders of long-term debt have no ownership in the company but are the first to be repaid if the company goes bankrupt.
This makes long-term debt a "safer" investment from a priority perspective but doesn't offer the growth potential found in common stocks.
Thus, while long-term debt can provide steady income to investors, it lacks the upside that stock investments may offer.

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Most popular questions from this chapter

Income bonds are unusual. Interest payments on such bonds may be skipped or deferred if the firm's income is insufficient to make the payment. In what way are these bonds like preferred stock? Why might a firm choose to issue an income bond instead of preferred stock?

Preferred stock of financially strong firms sometimes sells at lower yields than the bonds of those firms. For weaker firms, the preferred stock has a higher yield. What might explain this pattern?

If there are 10 directors to be elected and a shareholder owns 90 shares, indicate the maximum number of votes that he or she can cast for a favorite candidate under a. majority voting b. cumulative voting

The authorized share capital of the Alfred Cake Company is 100,000 shares. The equity is currently shown in the company's books as follows: $$\begin{array}{lr}\hline \text { Common stock (\$1.00 par value) } & \$ 60,000 \\\\\text { Additional paid-in capital } & 10,000 \\\\\text { Retained earnings } & 30,000 \\\\\text { Common equity } & 100,000 \\ \text { Treasury stock (2,000 shares) } & 5,000 \\\\\text { Net common equity } & 95,000 \\\\\hline\end{array}$$ a. How many shares are issued? b. How many are outstanding? c. How many more shares can be issued without the approval of shareholders?

Other things equal, will the following provisions increase or decrease the yield to maturity at which a firm can issue a bond? a. A call provision b. A restriction on further borrowing c. A provision of specific collateral for the bond d. An option to convert the bonds into shares
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