Question

Corporations raise capital through issuing common stock, preferred stock and bonds.

a) Explain the basic chacacteristics of each type of security

b) List and explain the advantages and disadvantages of issuing each type of security from the point of view of the corporation

b) List and explain the advantages and disadvantages of investing in each type of security from the point of view of the investor

Answer 1

a) Raising capital through the issue of common stock leads to dilution of ownership in the organization. They need to necessarily be paid dividends and are the last to be paid in the event of liquidation and bankruptcy, so the cost of capital, of raising capital through common stock is the highest.

Raising capital through debt is the cheapest option and it does not lead to dilution of ownership. The debt holders however, needs to be paid first in the event of a liquidation or bankruptcy.

Raising capital through preference shares, leads to an obligation that they need to be paid dividends first, they have no voting rights, It is cheaper to raise capital through preference than common shares. It does not lead to dilution of ownership in the issuing company

b) The benefits of the issuing company, to issue preference shares is that they do not have to provide voting rights to them. The ownership is not diluted , as it is when the organization issues common shares. The cost of raising capital is also low, when an organization raises capital through preference shares. They have a right to repurchase shares.

The disadvantage is that , issuing company needs to pay a higher cost in comparison to debt.

The advantages of issuing company by issuing debt is that, they have the lowest cost of capital. The disadvantage is that, they need to be paid first and full , failing which the organization can lead to bankruptcy.

The advantage of raising capital through common share is that they need not necessarily be paid dividends. They need to be paid last in the event of liquidation. The disadvantage is that, raising capital through common shares is the most expensive option for the issuing company.

b) When an investor invests is preference shares, the advantages they receive is that, they receive dividends before the common share holders. They have priority claim over the income and assets of the organisation, in the event of liquidation and bankruptcy.
A disadvantage is that, they have no voting rights.

The advantages of debt holders is that, they have security in the event of liquidation and bankruptcy, They are the first to be paid as non payment to the debt holders can lead an organization to bankruptcy.

The disadvantages of the debt holders is that , they have the lowest cost of capital in comparison to the other sources of capital.

The advantages of common share holders is the highest cost of capital that they receive by investing their money in the organisation.

The disadvantage is that they have the least priority in the event of liquidation as well as zero voting rights.