Question

Meadowink Inc. has decided to expand its operations to owning and operating golf courses. The following is an excerpt from a conversation between the chief executive officer, Jodi, and the vice president of finance, Dan:

Jodi: Dan, have you given any thought to how we're going to manage the acquisition of Murrysville Golf Course?
Dan: Well, the two basic options, as I see it, are to issue either preferred stock or bonds. The equity market is a little depressed right now. The rumor is that the Federal Reserve Bank is going to increase the interest rates either this month or next.
Jodi: Yes, I've heard the rumor. The problem is that we cannot wait around to see what is going to happen. We will have to move on this next week if we want any chance to complete the acquisition of the golf course.
Dan: Well, the bond market is strong right now. Maybe we should issue debt this time around.
Jodi: That is what I would have guessed as well. Murrysville Golf Course's financial statements look pretty good, except for the volatility of its income and cash flows. But that is characteristic of the industry.

Discuss the advantages and disadvantages of issuing preferred stock versus bonds.

Answer 1

Advantages: While interest payments on bonds are legal obligations that are payable before taxes there are no such obligations in case of preferred stock. In case of non-cumulative preference shares the company will not have to pay those dividends in the future.

Disadvantages: Meadowink Inc. will have to keep in mind the fact that investors are skeptical of preferred stocks compared to bonds because they have a lower claim on company assets in case the company goes into liquidation. To compensate for this risk owners of preference shares have to be paid more than to owners of bonds and this increases the costs for the company. Investors are often hesitant to buy preferred stock and this is another disadvantage of issuing preferred stock versus bonds.