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In: Finance

A firm has common and preferred stock outstanding, both of which just paid a dividend of...

A firm has common and preferred stock outstanding, both of which just paid a dividend of $3 per share. Which do you think will have a higher share price and why? If the firm also has an issue of non-callable debentures outstanding, which do you think investors will require a higher return on, the debentures or the shares of common stock? Explain.

Solutions

Expert Solution

Preferred stock, as its name suggests, has greater claim to companies assets over the common stocks. So in a sense common stocks are more riskier than the preferred stock. Moreover, dividend on preferred stock are paid on regular interval, unlike common stock, which depends upon management discretion.

So, in a nutshell, common stock are more risky to hold than preferred stock, so the investor will demand premium to hold that, which will result in the share price of common stock to be more than preferred stock

This can also be explained by the example.

Preferred stock

Dividend = $3 ( this will remain constant throughout life)

Lets say interest rate = 10%

So preferred stock price = D/r = 3 / 0.1 = $30

Common Stock

Dividend = $3

Growth rate of dividend = 2%

Interest rate = 10%

Price = D * (1+g) / (r-g)

Price = 3 * (1.02) / 0.08 = 38.25

Debentures are basically securities with fixed interest rate. So this is debt which a company issue to raise money. Debt is always less riskier than the equity as investor in debt instruments will get timely interest payment no matter how company is doing. But this is not the case for equity investor.

So common stock, since it is more riskier, require higher return


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