End-of-chapter questions. 8-1. Preferred stock is often referred to as a hybrid security

8-1. Preferred stock is often referred to as a hybrid security. This is because preferred stock has many characteristics of both common stock and bonds. It has characteristics of common stock, such as no fixed maturity date, nonpayment of dividends does not force bankruptcy, and the nondeductibility of dividends for tax purposes. But it is like bonds because the dividends are fixed in amount like interest payments. From the point of view of the preferred stockholder, this is not the most advantageous combination. On one hand, the dividends are limited as with bond interest, but the security of forced payment by the threat of bankruptcy is not there. Thus, from the point of view of the investor, the worst features of common stock and bonds are combined.

8-2. To a certain extent, preferred stock dividends can be thought of as a liability. The major difference between preferred dividends in arrears and normal liabilities is that nonpayment of them cannot force the firm into bankruptcy. However, since the goal of the firm is common shareholder wealth maximization, which involves getting money to the common shareholders (dividends), preferred arrearages provide a barrier to achieving this goal.

8-3. A cumulative feature requires all past unpaid preferred stock dividends be paid before any common stock dividends are declared. A stockholder would like preferred stock to have a cumulative dividend feature because without it there would be no reason why preferred stock dividends would not be omitted or passed when common stock dividends were passed. Since preferred stock does not have the dividend enforcement power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred stockholders.

Other frequent protective features serve to allow for voting rights in the event of nonpayment of dividends or to restrict the payment of common stock dividends if sinking-fund payments are not met or if the firm is in financial difficulty. In effect, the protective features included with preferred stock are similar to the restrictive provisions included with long-term debt.

8-4. Fixed rate preferred stock has dividends that do not vary from the fixed amount or from period to period.

Adjustable rate preferred stock is preferred stock that has quarterly dividends that fluctuate with interest rates under a formula that ties the dividend payment at either a premium or discount to the highest of the three-month Treasury bill rate, the 10-year Treasury bond constant maturity rate, or the 20-year Treasury bond constant maturity rate. The rates have maximum and minimum levels called the dividend rate band.

The purpose of allowing the dividend rate to fluctuate is to minimize the fluctuation in the value of the preferred stock. It is also very appealing in times of high and fluctuating interest rates.

8-5. With PIK (payment-in-kind) preferred stock, investors receive no dividends initially; they merely get more preferred stock, which in turn pays dividends in even more preferred stock. Usually after 5 or 6 years, if all goes well for the issuing company, cash dividends should replace the preferred stock dividends, generally ranging from 12 percent to 18 percent, to entice investors to purchase PIK preferred.

8-6. Convertibility allows a preferred stockholder to convert or exchange preferred stock for shares of common stock at a predetermined exchange rate. This option gives preferred stockholders more freedom in investment decisions by allowing them to convert into common stock at their discretion. It gives the preferred stockholder a higher cash return than the common stock but allows for sharing in some of the future appreciation of the common stock if they convert the stock.

Preferred stock may be callable by the issuer so that in the event interest rates decline and cheaper funding becomes available, the stock may be called and new securities may be issued at a lower cost. To agree to the call feature, the investor requires a slightly higher rate of return. Call of a convertible preferred stock enables a company to turn the preferred stock into common equity; i.e., calling it without having to spend the cash.

8-7. Both values are based on future cash flows to be received by stockholders. Preferred stock typically has a predetermined constant dividend. For common stock, the dividend is based on the profitability of the firm and on management’s decision to pay dividends or to retain the profits for reinvestment purposes. Thus, the growth of future dividends is a prime distinguishing feature of common stock.

8-8. The expected rate of return is the rate of return that may be expected from purchasing a security at the prevailing market price. Thus, the expected rate of return is the rate that equates the present value of future cash flows with the actual selling price of the security in the market.

8-9. The required rate of return is the discount rate that equates the present value of future cash flows with the intrinsic value of the security. As with the internal rate of return for a capital budgeting problem, we have to find the rate of return that sets the future cash flows equal to the cost of the security. This rate may have to be developed by trial and error.

8-10. The two types of return are dividend income and capital gains. The dividend income for common stockholders differs from preferred stockholders, in that no specified dividend amount is to be received. However, the common stockholders are permitted to participate in the growth of the company. As a result of this growth, their second source of return, price appreciation, is realized.

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