Preferred Stock, Warrants, and
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
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:
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:
How does preferred stock differ from both common equity and debt?
preferred stock more risky than common stock?
What is floating rate
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.
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
Finally, preferred stockholders can normally elect several directors if preferred
dividends are omitted for some period, generally three consecutive quarters.
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.
21 - 1