Textbook Problem

For purposes of measuring a firm’s leverage, should preferred stock be classified as del equity? Does it matter whether the classification is being made (a) by the firm’s man ment, (b) by creditors, or (c) by equity investors?

Summary Introduction

To Determine: Whether the preferred stock be categorized as debt or equity and the reasons on whether the categorization is prepared by firm's administration, creditors or by the equity investors.

Introduction: Leverage is the utilization of debt by an organization to finance its operations and extension projects with an end goal to produce an return for investors. Organizations that forcefully utilize debt financing are measured profoundly leveraged and commonly riskier to invest.

Explanation of Solution

The reasons on whether the preferred stock be categorized as debt or equity and the reasons on whether the categorization is prepared by firm's administration, creditors or by the equity investors is as follows:

The preferred stock is categorized simply when the one undertaking the categorization is measured. From the point of view of the firm, preferred stock resembles equity in that it cannot compel the firm into liquidation, yet it resembles debt in that it source changes in profit accessible to the common stockholders. Subsequently, if the firm is apprehensive basically with existence, it would most categorize preferred stock as equity. Nonetheless, if there is basically no risk of insolvency or bankruptcy, the administration would see preferred stock as essentially another fixed charge bond and regard it inside as debt.

The equity investors would have a comparable perspective, and all in all they should look after the preferred stock in much indistinguishable way from debt. As far as creditors are concerned, the position is switched. They take inclination over preferred investors, and the preferred issues go about as a pad. Thus, a bond expert would likely need to regard preferred as equity. Clearly, in every one of these claims, there would need to be a few capabilities, in a stringent logic, preferred stock is either considered as a debt or as an equity, however it is considered as hybrid.