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Blah kndcjoqwn oancqwp opjc fnoqwnjo ipoqwndc qnjpo cj jd [pqnj qdn fjoqwp cjj 0pjci ewn inkdfn a cknma iodfn q dnijnefr mfowpjcf w. Although preferred stock financing is a less risky means to acquire financial

leverage, the other difference between it and debt financing argues

strongly against the use of preferred stock. Since interest is a tax-deductible

expense and the preferred dividends are not, the effective cost of debt financing

is cheaper. If a firm borrows at 8 percent, the true cost is reduced as a

result of the tax laws. If a firm issues preferred stock and pays an 8 percent

dividend, the true cost to the firm is 8 percent. Because the cost of debt financing

is shared with the government, firms tend to use debt instead of preferred

stock as a means to obtain financial leverage.

The inability to deduct preferred dividends reduces the impact of financial

leverage. The difference in the return to the common stockholder that results

from the use of debt and preferred stock financing is illustrated in the following

example. The firm issues $50 worth of common stock and needs an additional

$50. It may issue either $50 of debt with a 5 percent interest rate or $50

of preferred stock with a 5 percent dividend. In both cases the firm acquires

$50 and pays out $2.50 in either interest or dividends. However, the earnings

available to the common stockholder are larger when debt is used instead of

preferred stock. This is shown in the following income statements: