Question

In: Accounting

A firm has common and preferred stock outstanding, both of which just paid a dividend of...

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

Solutions

Expert Solution

let's first understand the difference between the common stock and preferred stock.

both stocks pay dividend and has claim over the assets of the company but as the name suggests, preferred stock has a preferance over the claim of the company than the common stock holders and also preferance share holders has a preferance over dividends than of the common stock holders.

but prefrence share holders receive a fixed amount of dividend every year irrespective of the earnings of the company. this concludes that preferance shares are riskier for the company.

however, dividend on common stock depends on the company's descrition to announce the dividend. dividends generally have a growth rate but preferance dividend do not have growth rate.

if $3 dividend is announced on both the shares, and rate of return is 10% for the company and growth rate for common stock be 2%, then the preferance share price woud be 3/10%= $30 per preferance share

and common stock price would be 3/(10%-2%) = $37.5

thus this example illustrates that common stock is highly priced over the preferance stock.

noncallable debenture are the securities which can not be redeemed before the maturity of the debenture or redeemed with the penalty.

debentures also require a fixed interest rate over the variable dividend payments on the common stock. and debentures also have a priority claim on company's assets over the common stock holders

thus for investors, debentures are less riskier than common stock. common stock holders are at higher risk because of irregular and variable dividend payments and least priority over company's assets claim, hence the common stock being more riskier expects higher return on the stock over the dedbenture holders.

thanks

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