Discuss the advantages and disadvantages of issuing preferred stock vs bonds. CP

Question

Discuss the advantages and disadvantages of issuing preferred stock vs bonds.

CP 12-4 Preferred stock vs. bonds c. has decided to expand its operations to owning and operating golf courses. The following is an excerpt from a conversation between the chief executive officer, Peter Kilgallon, and the vice president of finance, Dan Baron. Peter: Dan, have you given any thought to how we're going to the acquisition of Sweeping Bluff Golf Course? Dan: Well, the two basic options, as I see it, are to issue either preferred stock or bonds. The equity market is a little de- pressed right now. The rumor is that the Federal Reserve Bank's going to increase the interest rates either this month or next. Peter: Yes, I've heard the rumor. The problem is that we can't wait around to see what's going to happen. We'll have to move on this next week if we want any chance to complete the acquisition of Sweeping Bluff Golf Course. Dan: Well, the bond market is strong right now. Maybe we should issue debt this time around. Peter: That's what I would have guessed as well. Sweeping Bluff Golf Course's financial statements look pretty good, except for the volatility of its income and cash flows. But that's characteristic of the industry. Discuss the advantages and disadvantages of issuing preferred stock versus bonds.

Explanation / Answer

What are preferred stocks?
A preferred stock is generally considered between to a bond and common stock in the sense that it pays fixed dividends like a bond but takes lower precedence than a bond in case of liquidation proceedings.
Advantages
Preferred stocks generally have a lower par value than bonds, thereby requiring a lower investment.
Preferred stocks have a higher yield than bonds to compensate for the higher risk.
Institutional investors like preferred stocks due to the preferential tax treatment the dividends receive.
Disadvanatages
There are several advantages of issuing bonds or other debt instead of stock when acquiring assets. One advantage is that the interest on bonds and other debt is deductible on the corporation's income tax return. Dividends on stock are not deductible on the income tax return.

A second advantage of financing assets with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation.

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