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Variable-Rate Preffered Stock

Variable-Rate Preffered Stock

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Published by ClassOf1.com
Preferred stock has frequently been issued in connection with mergers and acquisitions. Often the preferred stock is issued with a conversion feature, so in the long run there is a probability it will become common stock capital. Preferred stock allows the acquired firm’s owners a prior claim relative to common stock and reasonably definite dividends while simultaneously giving the acquiring firm a form of leverage without strapping it with the rigid obligations of debt.
Preferred stock has frequently been issued in connection with mergers and acquisitions. Often the preferred stock is issued with a conversion feature, so in the long run there is a probability it will become common stock capital. Preferred stock allows the acquired firm’s owners a prior claim relative to common stock and reasonably definite dividends while simultaneously giving the acquiring firm a form of leverage without strapping it with the rigid obligations of debt.

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Published by: ClassOf1.com on Jun 19, 2013
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03/03/2014

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Finance
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Sub: Finance Topic: Stock Management
*
Variable-Rate Preferred Stock
 
Preferred stock
has frequently been issued in connection with mergers and acquisitions. Often thepreferred stock is issued with a conversion feature, so in the long run there is a probability it willbecome common stock capital. Preferred stock
allows the acquired firm’s owners a prior claim
relative to common stock and reasonably definite dividends while simultaneously giving the acquiringfirm a form of leverage without strapping it with the rigid obligations of debt. This provides a justification for the fact that some firms do issue preferred stock. However, on a pure explicit costcomparison with debt, preferred stock tends to be inferior (have a higher after-tax cost).A firm notmaking sufficient taxable income to use the tax shield of the debt may have incentive to use preferredstock, as will a firm close to its debt capacity.Preferred stock is similar to debt, and the factors affecting the cost of debt are also important here. If the preferred stock is only slightly more risky than the debt, then it could yield less than debt beforetax and still return enough in excess of the yield on debt after tax to compensate a corporate investorfor the additional risk. Some treasurers of corporations would like to invest in preferred stock havingbefore-tax yields about the same as (or somewhat less than) short-term debt if some of the risk of preferred stock can be removed. One risk that investors would like to see removed is the risk that theprice of preferred stock will fall because the market
’s required return has gone up.
Variable-ratepreferred stocks
are one method of insuring that the stock price will not fall. Rather than paying afixed dividend, this type of security pays a dividend that is a fixed fraction of the highest of as many asthree government bond yields (
e.g
., the T-bill rate, the U.S. Treasury 10-year constant maturity rate,and the U.S. Treasury 20-year constant maturity rate). The advantage of a variable-rate preferredstock is that its market price should always be close to its face value. If the payment risk does notchange, it will differ only because the linkage to the U.S. Treasury securities does not perfectly reflect
 
 
Sub: Finance Topic: Stock Management
*
the market
’s required return on preferred
stock. To protect the issuing firm against very large cashoutlay commitments, a maximum dividend rate is established. To protect the investor against verylow dividends, a minimum dividend rate is established. While not necessary to the basic concept of the security, these provisions are generally present, but the levels of maximum and minimum varygreatly. Also, the differential between the maximum of the three U.S. Treasury returns and thepreferred stock dividend also differs from issue to issue. These factors are set by market conditions(supply and demand) for this particular type of security.

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