Explanation: The dividend rate on preferred stock should be higher than the interest rate on long term debt. This is because the dividend rate on preferred stock and the interest rate on long term debt are the part of the costs of the respective sources of financing. The investors in the debt are assured of being paid a fixed amount of interest and principal amount at the time of redemption of the long term debt. On the other hand the dividend on preferred stock is paid only in case profits of the company which increases the risk of the investors who invest in preferred stocks. They are thus offered a higher dividend rate to compensate for the excess risk they assume by investing in preferred stock.
(c)higher than the interest rate on long-term debt.
Preferred stock is not an obligation of the company and the company can stop paying dividends just by vote of the Board. In bankruptcy, preferred stock is subordinate to the every debt of the company. Long-term debt obviously is an obligation and a company who doesn't make timely interest and principal payments is forced into bankruptcy. If yields were the same you would always take long-term debt over preferred stock (and there are some other ceteris paribuses in there as well like the preferred is not convertible).
And, uh, Richard this is pretty fundamental finance and you should contemplate what you are doing answering questions about finance without knowing this.
Edit: "on the other hand the dividend on preferred stock is paid only in case profits of the company" Must be stupid Tuesday or something. No...dividends on preferred stock are paid if there is any way that the company can do it. Not paying dividends on preferred stock is a really bad omen for continued corporate survival especially if the preferred is cumulative which means all dividends in arrears must be paid before common gets anything. There is no Board anywhere that says "We weren't profitable. Suspend the preferred". They say "Can anyone think of any other way of avoiding bankruptcy other than suspending the preferred?".
D The dividend rate will be set by market factors existing at the time of issuance.
The dividend rate on preferred stock should be:
(a)lower than the interest rate on the long-term debt.
(b)equal to the interest rate on long-term debt.
(c)higher than the interest rate on long-term debt.
(d)indeterminate from the information provided.
Explain with reason.
