Preferred Stock

Preferred stocks have the following advantages, except: (a) they are available in a wide range of quality ratings. (b) they generally have high unit cost. (c) they have attractive yields. (d) they offer a relatively high degree of safety.

B. Many preferreds sell between $25 and $50 per share.

Which one of the following statements is true? (a) As interest rates move up, yields on preferreds move down. (b) As interest rates move up, the price of a preferred stock will also move up. (c) The price behavior of preferred stock is inversely related to market interest rates. (d) To define the price of a pref erred stock, you divide the market yield with the preferred's annual dividend.

C. As with bonds, when rates go up, prices drop.

The price of $100 par 6% dividend preferred stock is $100 if investors require a 10% rate of return. (T/F)

False. Price is $60 =(0.06 ×100)/0.10.

A preferred issue with a sinking fund provision will have a higher yield than a non-sinking fund issue. (T/F)

False. The sinking fund issue will have a lower yield because of lower risk to the investor.

Bob's Bells has earnings before interest and taxes of $10 million. The company pays $2 million in annual interest and $1.5 million preferred dividends. What is the company's fixed charge coverage? The firm faces a 35% tax rate.

Fixed charge coverage = earnings before interest and taxes / (interest + preferred dividends/0.65) 10 / (2 + 1.5/0.65) = 10/4.31 = 2.32 times

Other things being equal, higher fixed charge coverage means lower default risk on a preferred issue. (T/F)

True. Because the company has more earnings (and hopefully cash) to pay the dividends.

MIPS appeal to individual investors due to their monthly income feature—as opposed to conventional preferreds, which pay quarterly dividends. (T/F)

True. Straight preferreds pay dividends quarterly, just like common stock; MIPS pay monthly.

Preferred stock may produce a lower yield than a comparably rated bond. (T/F)

True. This is because up to 70% of dividends received by one company from another company are excluded from taxable income. This tax effect is reflected in market returns.

A preferred issue currently sells at $40 per share and pays a $1 annual dividend. An investor feels that prevailing market yield in two years will be 8%. (a) What is the present dividend yield? (b) What is the expected price of the issue in two years?

a) Dividend yield = dividend/current price $1/$40 = 2.5%. (b) Price = $1/0.08 = $12.50

Preferred stock dividends are fixed obligations, which can be waived only by a vote of the preferred stockholders. (T/F)

false. Preferred dividends are fixed financial obligations, but can be waived by the company's directors if the required income level is not attained.

Preferred stocks can be described as a special class of common stock. (T/F)

false. Preferred stock is equity but not common stock. Preferred stockholders do not normally vote and are not residual claimants as common stock shareholders are.

When preferred stock is cumulative, any dividends in arrears automatically accumulate and are used to purchase additional shares of the preferred stock. (T/F)

false. The cumulative provision requires the company to pay current dividends and any dividend arrearage to the preferred stockholders before any dividends can be distributed to the common stockholders.

The most popular investment strategy using preferred stocks is to speculate on turnaround situations. (T/F)

False. The most popular strategy for using preferreds is for high current income.

A preferred stock quote identified by pr instead of pf indicates the issue is selling above its par value. (T/F)

False. The symbol 'pr' indicates a preference or senior issue of preferred.

Adjustable-rate (floating-rate) preferreds carry dividends that are adjusted periodically in line with yields on the company's outstanding corporate bonds. (T/F)

False. Those yields (thus dividends) are adjusted in line with yields on Treasury issues.

Preferred stock investors are exposed to business risk and interest rate risk. (T/F)

true. And purchasing price, financial, event, tax, and market risks.

Which one of the following statements is not true? (a) To hedge against rising rates, investors turn to adjustable-rate preferreds. (b) There is far less price volatility with adjustables than with fixed-rate preferreds. (c) If a company's preferred dividend obligations are in arrears, a corporation cannot make dividend payments on common shares. (d) Preferreds whose dividends are qualified have no advantage over trust preferreds.

D

Selma is considering the purchase of Timber line's non-callable, non-cumulative 8%, $100 par value preferred stock. Selma's required rate of return for investments of this risk is 12%. What is the investment value of this stock to Selma? (a) $100.00 (b) its market price (c) its book value (d) $66.67

D. Required return is the minimum return an investor will seek when selecting among alternatives. In this case, Selma's required return may be less than, equal to, or more than the prevailing market yield. Regardless of the prevailing market yield at its price, the maximum value for this preferred stock to Selma is $66.67 ($8/0.12).

Martin Products has outstanding preferred stock that pays a $2 dividend and faces a prevailing market yield of 6%. (a) What should the price of the preferred stock be? (b) What will happen to the price if the prev ailing market yield changes to 8%? To 4%? (c) Discuss the effect of changes in prevailing market yield on preferred share prices.

Price = dividend/yield (a) Price = $2/0.06 = $33.33 (b) Price = $2/0.08 = $25.00 Price = $2/0.04 = $50.00 (c) Price is inversely relate d to prevailing market yield.