Question

1. Why bonds and preferred stocks are considered fixed-income securities?

2. Why do corporations prefer a high-bond rating to a lower-bond rating on their debt securities?

3. Why is valuing common stock more difficult and less precise than valuing bonds?

4. How does a firm’s future growth rate affect common stock value?

Answer 1

# 1

Preferred shareholders are entitled to get a fixed percentage of dividends when the company makes profit. Unlike common equity, they have the preferential right to get dividend at the time of distribution of profit. Sometimes no dividends will be paid to common shareholders until the preference shareholders have been paid the dividends to them. Moreover, they are entitled to get the arrears of dividend if any in any financial year. This is why preferred stocks are considered as fixed-income securities.

Bonds provide fixed interest income to the investors throughout the life of the bond. The companies which issue bonds have to pay interest to the bond holders irrespective of profits. This is why bonds are considered as fixed-income securities.

# 2

The ratings of the bond influence interest rates, bond pricing etc. Higher rated bonds are considered as safer and more stable investments. Low credit rated bonds by a ratings agency, are below investment grade. These are considered more risky. This is why corporations prefer a high-bond rating to a lower-bond rating on their debt securities.

# 3

Valuation of Stocks is harder than that of bonds. Because the future cash inflows associated with a stock is more difficult to predict. The reason is that it does not have a fixed dividend payment. But in the case of bonds, they bear fixed interest payments. So it is easy to value the bonds since their inflows are certain.

# 4

The firm’s stock value is affected by its future growth rate. If a firm has growth potential the value of the company will increase. The investors believe that the firms with future growth rate will make profits in the future. This belief will be reflected in the stock price, and thus the common stock value will increase.