Preferred stock is a hybrid security, because it has some characteristics typica
ID: 2788870 • Letter: P
Question
Preferred stock is a hybrid security, because it has some characteristics typical of debt and others typical of equity The following table lists various characteristics of preferred stock. Determine which of these characteristics is consistent with debt and which is consistent with equity. Characteristics Dividends are fixed. Usually has no specified maturity date. Debt Equity Consider the case of Ferro Enterprises: At the present time, Ferro Enterprises does not have any preferred stock outstanding but is looking to include preferred stock in its capital structure in the future. Ferro has found some institutional investors that are willing to purchase its preferred stock issue provided that it pays a perpetual dividend of $10 per share. If the investors pay $110.22 per share for their investment, then Ferro's cost of preferred stock (rounded to four decimal places) will beExplanation / Answer
Preferred Stock
A Preferred Stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preference Shares generally have a dividend that must be paid out before dividends to common shareholders, and the shares usually do not carry voting rights. Preferred Stock combines features of debt, in that it pays fixed dividends and equity, in that it has the potential to appreciate in price. The Details of each preferred stock depend on the issue.
So for the above mentioned characteristics, following is the analysis:-
a) Dividends are fixed :- This characteristic has been taken from Debt as they carry a fixed rate of interest.
b) Usually has no specified Maturity Date:- This characteristic has been taken from Equity Shares as they have the clause of no specified Maturity Date.
Case of Ferro Enterprises :-
First Part :-
Perpetual Dividend = $ 10 Per Share
Selling Price Per Share = $ 110.22 Per Share
Cost of Preferred Stock = Dividend of Preferred Stock = $ 10 = 9.0728%
Price of Preferred Stock $ 110.22
Second Part :-
If a firm cannot invest retained earnings to earn a rate of return greater than the required rate of return on retained earnings, it should return those funds to its Stockholders.
The Cost of Equity using CAPM Approach :-
Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)
where Beta = sensitivity to movements in the relevant market.
and Market Risk Premium = market rate of return – risk free rate of return
Given above, Current Risk Free Rate of return = 4.67%
Market Risk Premium = 5.75%
Beta = 1.56
Cost of equity = Risk free rate of return + Beta × Market Risk Premium
Cost of Equity = 4.67% + 1.56 (5.75%) = 4.67% + 8.97% = 13.64%
Therefore, Burris's Cost of Equity is 13.64%
Cost of Equity using the Bond yield plus risk premium Approach :-
Bond Yield = 11.52%
Risk Premium on its stock over Bonds = 5.89
Lincoln's Cost of Internal Equity = Bond Yield + Risk Premium = 11.52% + 5.89% = 17.41%
Option 3rd is correct as the result is 17.41%
Cost of Equity using the discounted Cashflow (or dividend growth) Approach :-
Market Price of a Share = $ 45.56
Expected Dividend per Share = $ 1.38
Growth Rate = 7.27%
Cost of Internal Equity = Expected Dividend Per Share + Growth Rate = $ 1.38 + 7.27% = 3.02% + 7.27%
Market Price Per share $ 45.56
= 10.30%
Option 1st is correct as the result is 10.30%
Estimating Growth Rates :-
Cash Dividend Distributed = 45.00
Return on Equity = 8 %
A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, paid to a class of its shareholders. Dividends can be issued as cash payments, as shares of stock, or other property.
Return on Equity (ROE) = Growth Rate
(1 - Payout Rate)
Therefore, Growth Rate = Return on Equity (ROE) * (1 - Payout Rate)
Growth Rate = 8 % * (1 -0.45) = 8 % * 0.55 = 4.40%
As no information is provided for total earnings, we assume $ 0.45 in a $1 or 45% out of earnings, Cash dividend is paid .