Ross. Westerfield. Jaffe. Jordan Chapter 14 Solution

Ross. Westerfield. Jaffe. Jordan Chapter 14 Solution -...

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CHAPTER 14 B- 1 CHAPTER 14 LONG-TERM FINANCING: AN INTRODUCTION Answers to Concepts Review and Critical Thinking Questions 1. The differences between preferred stock and debt are: a. The dividends on preferred stock cannot be deducted as interest expense when determining taxable corporate income. From the individual investor’s point of view, preferred dividends are ordinary income for tax purposes. From corporate investors, 70% of the amount they receive as dividends from preferred stock are exempt from income taxes. b. In case of liquidation (at bankruptcy), preferred stock is junior to debt and senior to common stock. c. There is no legal obligation for firms to pay out preferred dividends as opposed to the obligated payment of interest on bonds. Therefore, firms cannot be forced into default if a preferred stock dividend is not paid in a given year. Preferred dividends can be cumulative or non-cumulative, and they can also be deferred indefinitely (of course, indefinitely deferring the dividends might have an undesirable effect on the market value of the stock). 2. Some firms can benefit from issuing preferred stock. The reasons can be: a. Public utilities can pass the tax disadvantage of issuing preferred stock on to their customers, so there is substantial amount of straight preferred stock issued by utilities. b. Firms reporting losses to the IRS already don’t have positive income for any tax deductions, so they are not affected by the tax disadvantage of dividends versus interest payments. They may be willing to issue preferred stock. c. Firms that issue preferred stock can avoid the threat of bankruptcy that exists with debt financing because preferred dividends are not a legal obligation like interest payments on corporate debt. 3. The return on non-convertible preferred stock is lower than the return on corporate bonds for two reasons: 1) Corporate investors receive 70 percent tax deductibility on
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CHAPTER 14 B- 2 dividends if they hold the stock. Therefore, they are willing to pay more for the stock; that lowers its return. 2) Issuing corporations are willing and able to offer higher returns on debt since the interest on the debt reduces their tax liabilities. Preferred dividends are paid out of net income, hence they provide no tax shield. Corporate investors are the primary holders of preferred stock since, unlike individual investors, they can deduct 70 percent of the dividend when computing their tax liabilities. Therefore, they are willing to accept the lower return that the stock generates.
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CHAPTER 14 B- 3 4. The following table summarizes the main difference between debt and equity: Debt Equity Repayment is an obligation of the firm Yes No Grants ownership of the firm No Yes Provides a tax shield Yes No Liquidation will result if not paid Yes No Companies often issue hybrid securities because of the potential tax shield and the
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This note was uploaded on 04/18/2010 for the course FINANCE 936116531 taught by Professor Wuyiling during the Spring '10 term at Nashville State Community College.

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Ross. Westerfield. Jaffe. Jordan Chapter 14 Solution -...

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