Question

Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was

founded 5 years ago to provide educational software for the rapidly expanding primary

and secondary school markets. Although EduSoft has done well, the firm’s founder

believes an industry shakeout is imminent. To survive, EduSoft must grab market share

now, and this will require a large infusion of new capital.

Because he expects earnings to continue rising sharply and looks for the stock price to

follow suit, Mr. Duncan does not think it would be wise to issue new common stock at

this time. On the other hand, interest rates are currently high by historical standards, and

the firm’s B rating means that interest payments on a new debt issue would be prohibitive.

Thus, he has narrowed his choice of financing alternatives to: (1) preferred stock,

(2) bonds with warrants, or (3) convertible bonds.

As Duncan’s assistant, you have been asked to help in the decision process by

answering the following questions.

1. How does preferred stock differ from both common equity and debt?

Please provide any reference and in-text citations - TYIA

Answer 1

Preferred Stock can be looked upon as a mix of both common stock and debt.

Companies need to pay a fixed amount of dividend on preferred stock which is pre-determined when the stock is issued.

Some preferred stock also carries the feature of compulsory dividend while some carry features where dividend at fixed rate is only given if there are sufficient profits available.

Like in the above case, where issuance of both common stock and debt is not a feasible option, company may opt for a preferred stock.

Holders of preferred stock does not get voting rights in the company's shareholder's meetings.

Further, when the company is liquidated, they stand in line after the debt holders but before the common shareholders to receive money. Also, the company is not liable to redeem all of the preference shareholders unlike the debt holders where they are liable to settle the debt amount.