Stella Gregson received a windfall from one of her investments. She would like to invest $100,000 of the money in Shoreline Industries, which is offering common stock, preferred stock, and bonds on the open market. The common stock has paid $8 per share
in dividends for the past three years, and the company expects to be able to perform as well in the current year. The current market price of the common stock is $100 per share. The preferred stock has an 8% dividend rate, cumulative and nonparticipating. The bonds are selling at par with an 8% stated rate. Required: 1 . What are the advantages and disadvantages of each type of investment? 2 . Recommend one type of investment over the others to Stella and justify your reason.
1 . Common stock has ownership privileges. The residual of the company belongs to the common shareholders. Preferred stock has preference over common stockholders in dividend payouts. Bonds earn interest that is a legal obligation of the company.
2 . The return on the preferred stock depends upon its issue price. If it is assumed that the stock is issued at par value, the return is 8%. Since all three instruments yield the same rate of return, 8%, Stella should choose to invest in the bonds because they carry the lowest risk. As risk increases, the expected rate of return on an investment should increase.
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