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Web Chapter 16
Investing in Preferred Stocks
Outline
Learning Goals
I. Preferred Stocks
A. Preferred Stocks as Investments
1. Advantages and Disadvantages
2. Sources of Value
B. Issue Characteristics
1. Rights of Preferred Stockholders
2. Preferred Stock Provisions
Concepts in Review
II. Valuing and Investing in Preferred Stocks
A. Putting a Value on Preferred Stocks
1. Dividend Yield: A Key Measure of Value
2. Expected Return
3. Calculator Use
4. Book Value
5. Fixed Charge Coverage
6. Agency Ratings
B. Investment Strategies
1. Looking for Yields
2. Trading on Interest Rate Swings
3. Speculating on Turnarounds
Concepts in Review
Summary
Key Terms
Discussion Questions
Problems
©2017 Pearson Education, Inc.
306 Gitman/Joehnk/Smart • Fundamentals of Investing,Thirteenth Edition
Case Problems
16.1 Penni Shows a Preference for Preferreds
Excel@Investing
Chapter-Opening Problem
Key Concepts
1. The fundamental aspects of preferred stock, including sources of value and risk
2. Basic rights and claims of preferred stockholders and some of the common characteristics found with
these securities
3. Various measures of investment suitability and several preferred stock investment strategies
Overview
This web chapter is about preferred stock.
1. Preferred stocks are defined. Preferred stocks usually have fixed dividend characteristics. It might
be pointed out that high current income is an advantage of this investment vehicle. Investors should
be aware that many of the preferred shares outstanding can be classified as debt on issuers’ financial
reports.As a result, the dividends paid are treated as interest expense by the firm and therefore
deductible to the issuing firm, but from the investors’ point of view, do not qualify for the preferential
tax rate on dividends.Many newer issues, however, are structured so that they do qualify for the lower
rate.Investors need to be sure they know what they are buying when estimating the after-tax rate of
return from an investment in preferred stock.
2. Issue characteristics, investor rights and claims, cumulative provisions, and call and sinking fund
provisions are considered. Cumulative provisions are important and distinctive features of preferred
stocks that should be explained in detail. Adjustable-rate preferreds and preference preferreds are
also introduced and briefly discussed.
3. The next section outlines some ways of evaluating preferred stock for investment purposes. At this
stage, the following concepts should be reviewed carefully: how to calculate the expected yield of a
particular stock, how to reach an investment decision regarding that stock, and what preferred stock
agency ratings mean and where to obtain them. The instructor should explain to the class that the
value of investment-grade preferred stocks fluctuates with the market rate of interest and demonstrate
the inverse relationship with a specific example.
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Answers to Concepts in Review
1. Preferred stocks are equity issues that hold a position senior to common stock. Even though preferred
shares are a form of equity, they are considered fixed-income securities because their level of current
Some preferred stock dividends are treated as a financing cost and are tax deductible at the corporate
2. A share of preferred stock may be considered a hybrid security to the extent that it has some
characteristics of both equity and debt. Like common equity, preferreds pay dividends that may be
passed when corporate earnings fall below certain levels. They are also issued without maturity dates.
3. Advantages of preferred stock:
Disadvantages of preferred stock:
a. As with other fixed-income securities, preferreds are susceptible to the ravages of high rates of
©2017 Pearson Education, Inc.
308 Gitman/Joehnk/Smart • Fundamentals of Investing,Thirteenth Edition
4. Cumulative preferred and callable preferred refer to preferred shares with two different provisions,
each of which affects the investment merits of preferred issues. A cumulative provision means if any
Other things being equal, a cumulative preferred should be more highly valued than an issue without
5. The price of high-grade preferred stocks depends on the annual dollar dividend they pay and their
dividend yield. Because preferred dividends are fixed, the market price of preferred stocks depends on
Preferreds pay a constant level of dividends forever or until they are called (or until they begin to
Web Chapter 16 Investing in Preferred Stocks 309
b. Trading on interest rates. This strategy adopts an aggressive short-term posture and attempts to
capture capital gains. Becausepreferreds react to interest rate changes, like any fixed-rate
c. Speculating on turnarounds. This very aggressive strategy requires finding firms that have passed
preferred dividends and have had their investment ratings lowered; their preferreds will have
Suggested Answers to Discussion Questions
Preferred stock has a prior claim on income and assets (in bankruptcy) of the issuing firm. It also may
have a variety of special features.
b. Floating-rate preferredsdiffer because they give the security the ability to change the rate of
c. Prior preferred stocks have the distinction of being more senior than other preferred stock
d. Dividend payments on trust preferreds are expensed by corporations in a manner similar to debt
Although preferred stocks have the safety of a guaranteed annual payment, the payment is fixed.
2. Firms are not obligated to make preferred dividend payments. If conditions deteriorate in a firm to
the point where it needs to miss one or more of its preferred dividends payments, most preferred
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Solutions to Problems
1. Dividend yield
Annual dividend income
Preferred stock price
Price
Annual dividend income
Prevailing market yield
First, determine the current market price of the stock:
$5.40 dividend $5.40
Price $60.00
9% dividend yield 0.09
= = =
Now find the new dividend yield:
$4.50
Dividend yield = 7.5%
$60.00 =
New market price of preferred if dividend yield holds at 9%:
$4.50
New price $50.00
0.09
= =
New market price of preferred if yield drops to 7%:
$4.50
New price $64.29
0.07
= =
2.
Fixed charge coverage = Earnings before interest and taxes (EBIT)
Interest expense +[Preferred dividends/.65]
40,000,000
$2,000,000 ($1,000,000 / 0.65)
=+
40,000,000 11.3 times
$2,000,000 $1,538,462
= =
+
Note: In this equation, we use an assumed corporate tax rate of 35%.
Fixed charge coverage with EBITDA:
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Earnings before interest and taxes (EBIT) Depreciation Amortization
= Interest expense [ Preferred dividends (0.65) ]
40,000,000 5,500,000
$2,000,000 ($1,000,000 / 0.65)
45,500,000 12.86
$2,000,000 $1,538,462
+ +
+
+
=+
= =
+ times
Note:Because depreciation and amortization are noncash expenses, the firm actually has greater
3. Fixed charge coverage EBIT/(Interest expense Preferred dividends)
Note: Some students might carry over the $5,500,000 in depreciation and amortization from the prior
problem. In which case:
Fixed charge coverage EBITDA/(Interest expense Preferred dividends)
4. HPR (Current income Capital gains)/Initial investment
a. Here, capital gains and dividends would be taxed at 15%.
b. Here, capital gains are taxed at 15%, while the dividends are taxed at 25%.
5. The issue here is the tax rate on common stock dividends versus trust preferred stock dividends.
312 Gitman/Joehnk/Smart • Fundamentals of Investing,Thirteenth Edition
6. There is no set solution to this problem because the answer will vary with the preferred stock chosen
by the student. Students should be encouraged to get an actual quotation from the WSJ to answer a
7. For Sara-J’s preferred stock:
Annual dividend income
Price Prevailing market yield
$3.50 $46.67
7.5%
=
= =
Price using the dividend valuation model from Chapter 8:
Dividend
Price where Required rate of return
$3.50 $46.67
7.5%
r
r
= =
= =
Both methods yield the same results: The first method uses the perpetuity model for valuing the
8. First, find the future market price of the preferred if its yield falls to 6.5%:
Annual dividend income $7
Price Future market yield 0.065
$107.69
= =
=
If the market yield drops to 6.5% in two years, then Charlene will have an up front cash outflow of
$75.She will have an inflow of $7 one year later and an inflow of $114.69 ($7 + $107.69) in two
Solutions to Case Problems
Case 16.1 Penni Shows a Preference for Preferreds
This case is designed to have the student make decisions about preferred stocks. Both computations and
discussions about the investment merits of preferreds are involved.
a. Penni’s stockbroker expects the market yield to drop to 7% in two years.
Web Chapter 16 Investing in Preferred Stocks 313
b. Using a spreadsheet or financial calculator, we find the internal rate of return on this investment to be
c. If all expectations are realized, Ms. Jock’s average annual rate of return will be 23.44%, which is
clearly superior to 10%.Her alternative investment offers an annual rate of only 10%. If the two
d. Although this may be a quality preferred stock, the way it is being used (speculating on interest rate
movements) places the investor in a highly risky position. It offers a very attractive rate of return.
Even so, we cannot lose sight of the fact that the security offers a high but certainly not a guaranteed
Answer to Chapter-Opening Problem
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