Preferred Stock

Question 1

Distinguish between Convertible Preferred Stock and Nonconvertible Preferred Stock.

Answer 1

1. Convertible Preferred Stock = Preferred shareholders can exchange (convert) preferred stock for common stock.
2. Nonconvertible Preferred Stock = Preferred shareholders cannot exchange (convert) their preferred stock to common stock.

Question 2

Define “preferred stock”.

Answer 2

Ownership interest in a corporation which has certain preferences over common stock; often describes as have characteristics of both bonds and common stock.

Question 3

How is the currently expected rate of return on Preferred Stock (PSER) determined?

Answer 3

PSER = Annual Preferred Dividend/Market Price of preferred stock.
Note: This expected rate of return is the current cost of Preferred Stock capital.

Question 4

Distinguish between Participating Preferred Stock and Nonparticipating Preferred Stock.

Answer 4

1. Participating Preferred Stock = Preferred shareholders can “participate” with common shareholders in receiving dividends in excess of the preferred preference rate.
2. Nonparticipating Preferred Stock = Preferred shareholders cannot “participate” with common shareholders in receiving dividends in excess of the preferred preference rate; each period they receive only their preference rate of dividends.

Question 5

List the advantages of using preferred stock (for long-term financing).

Answer 5

1. No legally required periodic payments (i.e., dividends)
2. Lower cost of capital than Common Stock
3. Does not dilute Common Stock voting strength
4. No maturity date
5. No security required

Question 6

Define “callable preferred stock”.

Answer 6

The issuing firm has the right to buy back the preferred stock, normally at a premium.

Question 7

Distinguish between Cumulative Preferred Stock and Noncumulative Preferred Stock.

Answer 7

1. Cumulative Preferred Stock = Dividend preference amount not paid in any year accumulates and must be paid before common dividends are paid.
2. Noncumulative Preferred Stock = Dividend preference amount not paid in any year does not accumulate; it is “lost” t the Preferred Shareholder for that period.

Question 8

How is the theoretical value of a share of Preferred Stock (PSV) determined?

Answer 8

PSV = Annual Preferred Dividend/Investors’ Required Rate of Return
Note:
1. The annual dividend is assumed to exist in perpetuity.
2. The investors’ required rate of return is a “discount rate”.