Question

What are the basic features of preferred stock and explain its advantages and disadvantages. Explain what warrants are, how they are used, and analyze their cost to the firm. Explain what convertibles are, how they are used, and analyze their cost to the firm.

Answer 1

The basic features of preferred stock are

1. Preference in distribution of liquidation proceeds
2. Fixed dividend irrespective of amount of profits generated
3. The dividend payment is cumulative

Advantages

• The existing share holders can retain their current positions even after issuing preference shares as they do not affect the share holding
• Good alternative for debentures, as no charge or mortgage is required as in debentures.
• Lower cost when compared to equity shares
• Preference shares generally have the option of convertibility

Disadvantages

• Cumulative feature will make preference shares costlier than equity shares.
• No voting rights for preference share holder

Warrants

Warrants are the instruments which gives the holder a right to buy stock at a fixed and on specified time.

Stock warrants are issued by the company as an instrument giving right to buy shares after certain time. If the stock is performing good in the market then holder of warrant will exercise the option as the holder can get shares at a lower price than market price. Cost to the firm is that shares are to be issued at a price lower than market price.

Convertibles

Convertibles are securities which give the option to the holder debentures or preference shares to convert them to equity shares.

The feature of convertibility is given to securities right at the time of their issue. At the redemption or after elapsing certain period as per the conditions of securities the holder of such securities will be given an option to convert the securities into common shares.