FIL240 CH8 Review Questions
State how investors' expected rate of return is computed.
The expected rate of return is the discount rate that equates the present value of expected future cash flows with the value of the security.
Define investors' expected rate of return.
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 expected future cash flows with the actual selling price of the security in the market.
Why would a preferred stockholder want the stock to have a cumulative dividend feature and protective provisions?
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. Because preferred stock does not have the payment enforcement power of interest from bonds, the cumulative feature is necessary to protect the rights of preferred stockholders. Other protective features may allow for voting rights in the event of nonpayment of dividends or 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.
Compare valuing preferred stock and common stock.
Both stock values are based on expected 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.
Why is preferred stock frequently convertible? Why is it callable?
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 their investment decisions by allowing them to convert into common stock at their discretion. 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 will require a slightly higher rate of return.
Why is preferred stock referred to as a hybrid security? It is often said to combine the worst features of common stock and bonds. What is meant by this statement?
Many times preferred stock is referred to as a hybrid security because it has many characteristics of both common stock and bonds. It has characteristics of common stock: there is no fixed maturity date, the nonpayment of dividends does not force bankruptcy, and dividends are not deductible 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 stock shareholder, this is not the most delightful combination. On one hand, the dividends are limited as with bonds, 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.
The common stockholders receive two types of return from their investment. What are they?
The two types of return include 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, that of price appreciation, results.
Because preferred stock dividends in arrears must be paid before common stock dividends, should they be considered a liability and appear on the right-hand side of the balance sheet?
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. Consequently, preferred dividends are not reported on the balance sheet. However, because the goal of the firm is shareholder wealth maximization, which involves getting money to the shareholders (dividends), preferred stock arranges do provide an effective block for the common shareholders' goal of the firm.
