Ch 17

Question 1

Why might a company issue preferred stock?

Answer 1

o balance its capital structure and expand the capital base without diluting common stock ownership or incurring debt obligations.

Question 2

What is a major drawback of issuing preferred stock?

Answer 2

Dividend payments on preferred stock are not tax-deductible.

Question 3

Which investment has a higher before-tax yield: a debenture or preferred stock?

Answer 3

The debenture (unsecured bond) has a higher before-tax yield (6.71%) compared to preferred stock (6.35%).

Question 4

How does the after-tax yield of a bond compare to that of preferred stock in Alberta for an investor in the highest income tax bracket?

Answer 4

After-tax yield for bond = 3.49%, and for preferred stock = 4.17%.

Question 5

What are the tax rates for bond income and preferred stock income in Alberta?

Answer 5

ond income is taxed at 48%, while preferred stock income is taxed at 34.31%.

Question 6

What happens if preferred stock dividends are not paid in one year?

Answer 6

Dividends accumulate and must be paid in total before common shareholders can receive any dividends.

Question 7

What is the conversion feature in preferred stock?

Answer 7

Preferred stock may be converted into common stock at the option of the holde

Question 8

What is the call feature in preferred stock?

Answer 8

The company has the option to redeem or call the stock back.

Question 9

What is the retractable feature in preferred stock?

Answer 9

The investor has the option to redeem or sell the stock back to the company.

Question 10

What is the participation provision in preferred stock?

Answer 10

Once common stock dividends equal preferred stock dividends, both types of stock share equally in additional payouts.

Question 11

What is a floating rate dividend in preferred stock?

Answer 11

The company adjusts the dividend based on market conditions.

Question 12

What does par value refer to in preferred stock?

Answer 12

It refers to the stated value per share used to establish redeemable and dividend features.

Question 13

What is Dutch auction preferred stock?

Answer 13

A security matures every seven weeks, and it is sold through a subsequent bidding process.

Question 14

What is an income trust?

Answer 14

A trust fund financed by investors or unitholders, used to invest in operating companies with mature assets and provides high returns due to tax efficiency.

Question 15

How do income trusts improve a firm’s financing capabilities?

Answer 15

Income trusts help firms by allowing them to sell mature assets to the trust, improving financing and providing high yields to investors.

Question 16

How do risk and expected return vary across different security classes?

Answer 16

Common stocks typically have the highest risk and return, followed by preferred stock, with bonds being the least risky and offering the lowest return.

Question 17

What rights do common shareholders have?

Answer 17

Common shareholders have rights to claim residual income, vote on major decisions, and purchase new shares.

Question 18

What is cumulative voting?

Answer 18

: It allows minority shareholders to have representation on the board by concentrating their votes on fewer candidates.

Question 19

What is a rights offering?

Answer 19

It gives current common shareholders the first opportunity to buy new shares, protecting them from dilution.

Question 20

What is a poison pill strategy in corporate defense?

Answer 20

A rights offering initiated by a firm to defend itself from a hostile takeover by making the takeover more expensive.

Question 21

Why is preferred stock considered a hybrid security?

Answer 21

Preferred stock falls between debt and common stock, offering characteristics of both, such as fixed dividends (like debt) but equity ownership (like common stock).

Question 22

Benefits of Issuing Preferred Stock

Answer 22

It can raise capital without diluting common stock ownership or incurring debt obligations, which can be beneficial in balancing the capital structure.

Question 23

How does preferred stock offer more flexibility than debt?

Answer 23

Preferred stock does not have mandatory interest payments like debt and may have fewer restrictions on the company’s operations compared to debt covenants.

Question 24

Why are preferred stock dividends not tax-deductible?

Answer 24

Unlike interest payments on debt, dividends are discretionary and are paid out of profits after taxes, so they don’t qualify for tax deductions.

Question 25

What risks do preferred stockholders face compared to bondholders?

Answer 25

Preferred stockholders face higher risk since dividends can be suspended, and they are subordinate to bondholders in case of liquidation.

Question 26

How do cumulative dividends affect preferred stockholders?

Answer 26

If dividends are not paid in a given year, they accumulate and must be paid before common shareholders can receive any dividends.

Question 27

How does the call feature of preferred stock benefit the company?

Answer 27

The company can redeem the stock before the maturity date, allowing it to manage financing costs or repurchase stock at a more favorable time.

Question 28

How does preferred stock compare to debt in terms of risk?

Answer 28

Preferred stock is riskier than debt because dividends can be skipped, and preferred stockholders are paid after debt obligations, but before common stockholders.

Question 29

What makes income trusts different from bonds or preferred stock?

Answer 29

Income trusts invest in mature assets and distribute cash flows to unit-holders. Unlike bonds or preferred stock, income trusts rely on tax efficiency and asset performance to provide high yields.

Question 30

How do corporations use income trusts to attract investors?

Answer 30

Corporations use income trusts to sell mature assets and raise capital while providing high returns to investors due to the tax advantages and strong cash flows from those assets.