Impact of Issuing Prefered Shares

Issuing preferred shares will tend to increase a company’s a. Financial leverage. b. Debt-to-equity ratio. c. Weighted average cost of capital relative to issuing common stock. d. Long-term debt. And why?

A. Preferred stock is not debt so that wipes out b and d. Preferred stock costs less than common because it is higher on the food chain so that wipes out c. Preferred stock is borrowed money from the point of view of financial leverage so the more preferred stock, the more leverage.

JDV, yes that’s the correct answer, which I also obtained by elimination, but wasn’t sure of the ratoinale. Doesn’t equity increase when you issue preferred? So why is there more financial leverage? This should be same as issuing common stock. I won’t give any more clues, and will wait for further explanations.

It’s a semantic issue - there’s accounting leverage and financial leverage. Financial leverage includes preferred stock because preferred stock is essentially debt without the possibility of default. From a leverage point of view, the default issue doesn’t change anything.

I haven’t hear the answer they were looking for.

Dividends, paid either for preferred or for common stock, is not tax deductible, therefore the cost of either would be higher than that of debt. Common stock requires a higher return because it has greater risk than preferred stock: preferred stock has a cumulative dividend (although fixed and at the discretion of the board, it still has to be paid) while common stock not only is not cumulative but is also inferior to preferred stock, therefore financing with common stock increases the WACC more than preferred stock would => © is out. (b) and (d) are obviously out, preferred stock is not debt, although carries some of the characteristics.

Sorry, that’s still dancing around the answer, but not really stating why preferred issuance would increase financial leverage. Sure, common stock costs more (thus higher WACC), abd sure preferred is not debt, etc. But if financial leverage is D/E or A/E, and issuing preferred clearly increases E, why would financial leverage increase?

issue perferred stock decrease net income, because of the perferred dividend. Lower net income meanes high financial leverage.

I would say it deals with the concept of marginal cost of capital (yes, I know, some of the capital can be raised at WACC, but still MCC goes up as more capital is raised), but there is also the fix expense (preferred dividends) increasing DFL (% change EPS/% change EBIT).

Dreary Wrote: ------------------------------------------------------- > Sorry, that’s still dancing around the answer, but > not really stating why preferred issuance would > increase financial leverage. Sure, common stock > costs more (thus higher WACC), abd sure preferred > is not debt, etc. But if financial leverage is > D/E or A/E, and issuing preferred clearly > increases E, why would financial leverage > increase? Who says that financial leverage is d/e where d somehow doesn’t include preferred but e does? That’s just dumb. Preferred stock is debt in nearly every sense of the word except some rigid accounting or legal sense.

I think leverage means simply the extent to which the costs (of both Operation and/or Fund Generation) are fixed. as preferred stocks impose fixed funding cost, it tend to increase financial leverage bcoz preferred stocks div does not increase in the high earning year leveraging the earning for the common shareholders.

freewin3k > issue perferred stock decrease net income, because of the > perferred dividend. Lower net income meanes high financial > leverage. Yes, but equity increases by much more than the small decrease in NI due to paying preferred dividends. Remember, preferred shares were issued, which adds to equity. JDV > Who says that financial leverage is d/e where d somehow > doesn’t include preferred but e does? That’s just dumb. > Preferred stock is debt in nearly every sense of the word > except some rigid accounting or legal sense. I beg to differ with you sir, it is not about semantics or conventions…you can’t increase your leverage by reclassiifying things around or by playing with jargon, or adopting some specific convention. Whether you include preferred as debt or not, that does not change facts on the ground…your degree of leverage is not an accounting or semantic decision. map1: > but there is also the fix expense (preferred dividends) > increasing DFL (% change EPS/% change EBIT). Correct, but didn’t explain how. Where is the preferred in your equation? Dhaka: > …as preferred stocks impose fixed funding cost, it tend to > increase financial leverage bcoz preferred stocks div does not > increase in the high earning year leveraging the earning for > the common shareholders. That’s the correct way of saying it. Preferred shareholders do not participate in future growth of earnings, they only get a fixed amount, leaving the rest for the company. Sorry if I sounded too pedagogical over this.

Dreary Wrote: ------------------------------------------------------- >> JDV > > Who says that financial leverage is d/e where d > somehow > > doesn’t include preferred but e does? That’s > just dumb. > > Preferred stock is debt in nearly every sense of > the word > > except some rigid accounting or legal sense. > > I beg to differ with you sir, it is not about > semantics or conventions…you can’t increase your > leverage by reclassiifying things around or by > playing with jargon, or adopting some specific > convention. Whether you include preferred as debt > or not, that does not change facts on the > ground…your degree of leverage is not an > accounting or semantic decision. > Reclassifying things or semantics? I thnk you need to think about what I wrote a little more closely. The right way to think about preferred stock is as the most junior of debt. That’s not reclassifying anything since it was never classified in the first place except by you as “equity”. Since I think equity represents a call on assets, preferred stock is not equity in any sense that matters. And your degree of leverage is absolutely an unclear thing. Give me any company and I can come up with some infinite number of possible measures of leverage. In the end leverage is some fuzzy concept like how revenue growth translates into equity returns. There are los of possibilities. > map1: > > but there is also the fix expense (preferred > dividends) > > increasing DFL (% change EPS/% change EBIT). > > Correct, but didn’t explain how. Where is the > preferred in your equation? > > Dhaka: > > …as preferred stocks impose fixed funding > cost, it tend to > > increase financial leverage bcoz preferred > stocks div does not > > increase in the high earning year leveraging the > earning for > > the common shareholders. > > That’s the correct way of saying it. Preferred > shareholders do not participate in future growth > of earnings, they only get a fixed amount, leaving > the rest for the company. > So your point here is that you need to point out that preferred doesn’t participate in the future earnings growth of the company? In fact, it does. You should try owning it. Preferred stock is the more credit sensitive than any bond (with a few ceteris paribuses). The recovery value of preferred stock is 0 so any credit problems pound the preferred. o the extent that earanings growth translates into credi enhancement, preferred particpiates n earanings growth by increased certainty of getting paid. > Sorry if I sounded too pedagogical over this.

I’m with you, the main point is that if a company raises money while keeping the cost of that money fixed (as in debt and preferred), it creates more financial leverage than otherwise. Similar to operating leverage: if all the costs a company has are fixed (i.e., no variable costs), then the degree of operaing leverage is very high. A not so entirely perfect example would be an online database which charges per query. There is no variable cost…it’s operaing leverage is huge.