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mini-case-ch21 - Chapter 21 Hybrid Financing Preferred...

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Chapter 21 Hybrid Financing: Preferred Stock, Warrants, and Convertibles MINI CASE Paul Duncan, financial manager of Edusoft Inc., is facing a dilemma. The firm was founded five 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 that 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 with the firm’s B rating, the interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to two securities: (1) bonds with warrants or (2) convertible bonds. As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions: a. 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? Answer: Preferred stock is a hybrid--it contains some features that are similar to debt and some features that are similar to common equity. Like debt, preferred payments to investors are contractually fixed, but like common equity, preferred dividends can be omitted without putting the company into default and thus into bankruptcy. Note, however, that the provisions of most preferred stock issues prevent a firm from paying common dividends when the preferred dividend has not been paid. Further, preferred dividends are generally cumulative ; that is, dividends that are omitted accumulate (without interest) and must be paid before any common dividends can be paid. Finally, preferred stockholders can normally elect several directors if preferred dividends are omitted for some period, generally three consecutive quarters. Thus, preferred stock lies somewhere between common equity and debt in the risk/return spectrum. Floating rate preferred stock has a dividend payment that is indexed to the rate on treasury securities, so it almost always trades at par. Mini Case: 21 - 1
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b. What is a call option? How can knowledge of call options help a financial manager to better understand warrants and convertibles? Answer: A call option is a contract which gives the holder the right, but not the obligation, to buy some defined asset, say a stock, at a specified price within some specified period of time. A warrant is a long-term option, and a convertible has built into it an implied call option. If financial managers understand how call options are valued, they can make better decisions regarding the structuring of warrant and convertible issues.
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mini-case-ch21 - Chapter 21 Hybrid Financing Preferred...

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