Paul Duncan, Financial Manager Of Edusoft Inc, Facing D

Paul Duncan Financial Manager Of Edusoft Inc Is Facing the Dilemma T

Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm’s founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital. Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firm’s B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds. As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions. Answer Question: What is floating rate preferred stock?

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Floating rate preferred stock is a type of preferred equity instrument that offers itsholders a dividend that varies periodically based on a specified benchmark interest rate or index. Unlike fixed-rate preferred stock, which provides a constant dividend amount, floating rate preferred stock adjusts its dividend payments in response to changes in market interest rates, providing investors with a degree of interest rate risk management and potential protection against inflationary pressures.

The primary feature of floating rate preferred stock is the reset mechanism, where the dividend rate is periodically recalculated. This adjustment is usually tied to a benchmark such as LIBOR (London Interbank Offered Rate) or the Federal Funds Rate, plus a fixed spread or margin that compensates for the risk premium. For example, a floating rate preferred stock might pay a dividend equivalent to LIBOR + 2%. If LIBOR increases, so does the dividend, and vice versa. The reset period, which could be quarterly, semi-annually, or annually, determines how often these adjustments occur.

Floating rate preferred stocks provide several advantages for investors. Firstly, they offer the potential for higher income when interest rates rise, unlike fixed-rate preferred stock, which becomes less attractive as rates increase. Secondly, they tend to have lower interest rate risk compared to fixed-rate instruments when market rates fluctuate. For issuers, floating rate preferred stock can be an attractive alternative to debt because it usually does not carry voting rights and is considered part of equity, which does not increase the company's debt burden directly. However, for investors, the variable dividend introduces an element of uncertainty, but in rising interest rate environments, the potential for higher distributions makes them appealing.

From a financial perspective, issuing floating rate preferred stock can also help a company manage its capital costs more effectively in volatile interest rate environments. This flexibility reduces refinancing risk and can improve the company's credit profile by balancing fixed and floating obligations. Nonetheless, floating rate preferred stock is generally riskier than fixed-rate alternatives since dividend payments can increase unexpectedly when rates climb, and the preference in the capital structure means it has priority over common stock but typically subordinate to debt instruments in bankruptcy proceedings.

In the context of EduSoft's financing dilemma, floating rate preferred stock could be an appealing option if the firm anticipates interest rates will stabilize or decline, thereby minimizing the exposure to increasing dividend costs. It also might appeal to investors seeking higher yields with some protection against rising rates while avoiding the complexities or higher costs associated with issuing debt or convertible bonds.

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