Question

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

Answer 1

Common share will have a higher share price. The absolute amount of $3/share is same for both the instruments; however, dividend yields are generally much lesser in common shares as compared to preferred stock.

Furthermore, there is a higher chances of capital appreciation in common shares as compared to preference shares. This is because, net profit is available to common equity investors post payment of dividends to preference share holders. In other words, any surplus available after payment of dividends from the net profit is retained earnings belonging to common equity shareholders. Equity share holders expect higher returns since they bear higher risks as compared to other investors

When comparing non-callable debentures and common stock, investors will expect a higher return from common stock. Due to the following reasons :

• It is mandatory for the company to make interest payments on agreed terms to debenture holders (interest rates and frquency of payments is generally fixed)
• Company is liable to return the principal amount at the redemption to debenture holders, which is not the case for common stock (the company is not liable to return the investment to equity shareholders, irrespective of the profitability or liquidity position from a legal point of view. However, if shareholders are not adequately compensated, the market prices may drop)
• Since the debentures are non-callable, the issuer does not have an option to call back the debentures if the interest rates decline in the future. Hence, in this case the investors are at an advantage as compared to the issuer. Since, the interest earnings are predictable for the debenture holders, the interest rates will be lower.
• On the other hand, dividend amount is not fixed for equity holders. Furthermore, equity holders are last in the pecking order in terms of profit distribution. Also, there are chances of the investment value dropping in the secondary markets (non callable - Debentures are not as volatile), thus, because of the higher risk incurred, equity shareholders will expect higher returns