Question

1. Define preferred stock, describe some of its basic features, identify and briefly explain other types of preferred stock discussed in the chapter, and identify preferred’s advantages and disadvantages.
2. Characterize the various types of leases, discuss the financial statement effects of “off balance sheet financing,” perform the analysis necessary to make lease versus borrow-and-purchase decisions, and identify and briefly explain a few of the factors affecting leasing decisions.
3. Discuss warrants and the way in which corporations utilize bonds with warrants as an alternative means of raising investment capital, describe how warrants are valued, calculate the component cost of bonds with warrants, and discuss the wealth effects and dilution due to warrants.
4. Explain how convertible securities work, define the terms conversion ratio and conversion price, explain how they are valued, calculate the component cost of convertibles, and explain how convertibles affect the issuing firm’s capital structure.
5. Identify differences between warrants and convertibles.

Answer 1

Note: As per answering guidelines, only the first question can be answered.

Solution:-

Generally, if an investor wants to take higher risks, he invests in equity stocks wherein he can have the opportunity to make higher returns by taking higher risks. Similarly, if an investor wants to take lower risks, he invests in debt instruments of a company wherein he has to settle for comparatively lower rate of return in the form of interest while enjoying lower risks and higher safety of capital invested.

Preferred stock comes in the middle of equity stocks and debt instruments and can be seen as a hybrid version of equity and debt investments. It offers a higher return on investment as compared to a debt investment and lower as compared to equity stocks. Similarly, it carries higher risk as compared to the debt instruments and lower risk as compared to the equity stocks.

In simple words, Preferred stock is an instrument which gives investors a fixed rate of dividends as well as the right of repayment after debt holders but before equity stockholders. Therefore, the basic features of preferred stock are as follows:-

• Preference in dividend payment over equity shares
• Fixed rate of dividend for preference stockholders irrespective of company's profitability (Just like bonds and other debt instruments)
• Right of repayment after debtholders but before equity holders
• Can be traded in the secondary markets just like equity shares
• Generally, preferred stock doesn't enjoy voting rights
• Higher risk as compared to debt investments but lower as compared to equity stock
• Higher returns as compared to debt investments but lower as compared to equity stock

Types of preferred stocks:

1. Convertible preferred stock: These type of preferred stock can be converted into equity shares at a predetermined conversion rate
2. Cumulative preferred stock: If a dividend payment is missed by the company, it gets added to the next dividend payment such that the total dividend payment is given cumulatively
3. Exchangeable preferred stock: These type of preferred stock carry the right to be exchanged against a specified type of types of securities at a predetermined exchange rate
4. Perpetual preferred stock: These type of preferred stock don't carry the right to receive back the capital at a specified date in future

Advantages and disadvantages:

Advantages	Disadvantages
1) Offers a middle way to investors to enjoy a higher rate of return than a debt instrument while taking lesser risks as compared to an equity investment.	1) Right of repayment falls after debt investors. Therefore, it's risk is higher as compared to a debt investment
2) Fixed rate of dividend as well as a preference in dividend payment over equity stockholders	2) Fixed rate of dividends limits the possibilities of making higher returns when the company is highly profitable
3) Preferred stock is also a right in ownership in the company just like equity shares, however with a fixed dividend rate and priority in repayment	3) They don't generally carry voting rights in a general meeting
4) Can be listed and traded in secondary markets just like equity shares	4) Lower risks and fixed returns results in lower opportunities for capital appreciation