Benefits of common stock and preferred stock, Financial Accounting

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Evaluate the following statements, and explain why you agree or disagree.

(a)    In a recent interview, a Wall Street investment banker commented on the infrequent use of Preferred Stock by many companies: "I believe Preferred Stock is an underutilized form of financing: it provides relatively stable income, and Cumulative Preferred Stock pays dividends ahead of Common Stock, both of which investors like. As a consequence investors will accept lower returns on Preferred Stock than on Common Stock. More CFOs ought to take advantage of this benefit and issue Preferred instead of Common Stock."

(b)   The following are arguments proposed for why firms might be able to use more or less debt in their capital structure. First, firms that have more assets such as land and building, which can serve as collateral for borrowing, have more debt capacity. Second, firms that have more stable profits and cash flows have lower debt capacities. Third, firms with sales that are impacted very negatively if the firm approaches financial distress (because customers also expect the firm to be around to fulfill after-sales warranties) have higher debt capacity.

(c)    As debt increases in the firm's capital structure, the debt will become more risky. At the same time, equity will also become more risky. Given that both sets of investors bear more risk, it must be the case that the firm's asset beta also increases with leverage.

 

 

 


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