Question

Preferred stock is often called a hybrid security because it has some characteristics that are typical...

Preferred stock is often called a hybrid security because it has some characteristics that are typical of debt and others that are typical of common equity. The following table lists several characteristics of preferred stock. Determine which of these characteristics are consistent with debt securities and which are consistent with common stock.

Characteristic

Debt

Common stock
Its dividends are fixed in amount.
It has a par, or face, value.

Consider the case of Blue Hamster Manufacturing:

Blue Hamster Manufacturing pays an annual dividend rate of 13.20% on its preferred stock that currently returns 17.69% and has a par value of $100.00 per share. The preferred stock issue does not mature, and computes its annual dividend as the product of its dividend rate and its par value. What is the current market value of Blue Hamster’s preferred stock?

$102.98 per share

$74.62 per share

$80.59 per share

$65.67 per share

Suppose that there is high unemployment, which causes interest rates to fall, which in turn pulls the preferred dividend yield to 15.21%. Then the value of Blue Hamster’s preferred stock will_________ to_________ . This is because interest rates (and security returns) and security values are________ related.

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Homework Answers

Answer #1

Its dividend are fixed in amount- Consistent with debt securities as dividend are not fixed for equity instruments.

It has par or face value- Hybrid (as both debt and equity has a face value)

Given,

Annual dividend rate= 13.20%

Face value= $100

Dividend= Face value*Annual dividend rate

= $100*13.20%= $13.20

Return= 17.69%

Price of preferred stock= Dividend/Return

= 13.20/0.1769

= $74.62

Answer: Option B

Revised price= 13.20/0.1521= $86.79

This is because interest rates (and security returns) and security values are negatively related.

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