How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock?

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How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock?

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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.
 
How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock?

Explanation & AnswerSolution by a verified expert

Explanation

Preferred stock differs from equity and debt in a variety of ways. First, unlike common equity, there is a contractual obligation to pay dividend to the preferred stockholders. Moreover, unless the preferred stockholders are paid in full, the company is not eligible to pay dividend to the common stockholders. Secondly, unlike debt, the preferred stockholders are not paid dividends if the company suffers from a loss.
 
Preferred stockholders do not even have the voting rights as given to the common stockholders. Thus, they are treated as hybrid securities which have the characteristics of both, the debt and equity.
 
Since the payment in the form of dividend is given first to the preferred stockholders and then to the common stockholders, it has less risk as compared to the common stockholders. However, in the event of loss, the creditors are still paid but the company is not liable to pay dividend under such conditions. Thus, the preferred stock is more risky than the company's debt. Hence, the risk in preferred stock comes in between the risks of investing in equity and debt.
 
Floating rate preferred stocks are the stocks whose dividend rate is linked with the treasury rate. The treasury rate is determined based on the years to maturity of the preferred stock and the treasury security of the same period.

Verified Answer

Unlike equity, preferred stockholders are paid first in the form of dividend. In cases, if the company has not paid dividend on preferred stock, common equity is not eligible for any dividend payments.
 
In case of debt, the preferred stocks are not given any preference in the event of losses during a particular financial year. It means that the interest on debt is paid in case of a loss, but the dividend to the preferred stock is not paid in such cases.
 
The risk factor of preferred stock lies between the risk inherited in equity as well as debt securities. So, with preferred stock, there is a medium risk.
 
Floating rate preferred stocks are those whose dividend structure is linked to the rate of treasury securities of a country.

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