Submitted by: Submitted by dkurth02
Views: 153
Words: 258
Pages: 2
Category: English Composition
Date Submitted: 07/09/2012 05:01 PM
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: