VARIABLE-RATE PREFERRED STOCK
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. This provides a justification for the fact that some firms do issue preferred stock. However, on a pure explicit cost comparison with debt, preferred stock tends to be inferior (have a higher after-tax cost).A firm not making sufficient taxable income to use the tax shield of the debt may have incentive to use preferred stock, 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 before tax and still return enough in excess of the yield on debt after tax to compensate a corporate investor for the additional risk. Some treasurers of corporations would like to invest in preferred stock having before-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 the price of preferred stock will fall because the market’s required return has gone up. Variable-rate preferred stocks are one method of insuring that the stock price will not fall. Rather than paying a fixed dividend, this type of security pays a dividend that is a fixed fraction of the highest of as many as three 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...
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