Question

1. Why do callable bonds typically have a higher yield to maturity than noncallable bonds, holding all other things constant? Is the yield differential between callable and noncallable bonds likely to be constant over time? Why?

2. Because the dividend payments on preferred stock are not a tax-deductible expense, the explicit cost of this form of financing is high. What are some of the offsetting advantages to the issuing firm and to the investor that enable this type of security to be sold?

3. The common stockholder is considered the residual owner of a corporation. What does this mean in terms of risk and return?

Answer 1

a. The callable bonds pose the investors with a reinvestment risk, as the callable bonds can be called by the issuer at any time. Generally, the issuer calls the bond, when the interest rate falls. As the interest rate falls, the issuer can the bonds, which leaves the investor with reinvestment risk as they now need to invest the money at a lower rate of interest.

No, the yield differences will not be constant over time, in the times of falling interest rates the yield offered by the callbale bonds have to be very high for the investors to buy these bonds due to the added risk factor attached to these bonds.

Due to this uncertainty, the interest/ yild to maturity on the callable bonds is high.

a. The preference share holders/ investors of preference share recieve a fixed amount as dividends. The preferred stocks are less risky than the common stock and it provides a stbale income.

Even though the dividends paid on preference share is not tax deductible. It is easier of the issuer to riase capital using the preference shares. By raising capital by issung preference shares a company can evade a higher load of debt as well.

a. The common stock holders recieve any payment in the profits of the company only when all the debt and prefernce share holders are completely paid off. So, they recieve a residual share in the company's profits, this reduces the retrun and increases the risk of the common share holders. The common share holders become onwers of the company by comtributing a share of capital and can lead to equity dilution within the company.