Answer to Question #237307 in Finance for Elijah Sichitalwe

Question

A company sources of long term funds include bonds, preferred stock and common stock. Identify some financing risks associated with these sources and explain how these risks affects the return expected from investments financed by these sources.

Answer 1

 The risks include interest rate risk, prepayment risk, credit, and liquidity risk.

Interest rate risk refers to the fluctuation of the market interest rate. When the market rate increases, the lenders are at a loss since they receive a lower return on similar risk bonds. Also, the issuer of bonds carries credit risk, that is, the risk of default. In such cases, the lender might not get periodic payments if the issuer goes bankrupt.

When the bonds are callable, then the investor might face reinvestment risk, in such cases, if the market interest starts declining, the bonds might be called back, and the yield earned on the investment would decrease. The investors would then have to invest their money at a lower interest rate.

When the risk on bonds increases, the expected return also increases. This is because the investors would want to be compensated more for the risk they are taking. This is the reason why lower-rated bonds give higher yields as compared to higher-rated bonds.

Preferred stocks have the characteristics of both debt and equity. They pay fixed dividends on the par value of the stock. Investors believe that preferred stocks provide higher dividend yields and have the potential for capital appreciation as well.

Preferred stock like bonds is exposed to interest rate risk. The value of preferred stocks decreases as the interest rate increases. In addition to this, they have liquidity risk and the risk of being called, as some companies can call them back when the interest rate starts declining in the market.

Therefore, to compensate, the investors expect a higher return. The risk associated with preferred stocks is more than bonds, and hence the expected rate of return on preferred stocks is usually more than bonds.

Common stocks are equity, and they are the riskiest type of financing of all three. This is because the owners of common stock will be the last to be compensated when the company gets liquidated or bankrupt. The investors do not have any guarantees in the form of periodic payments or capital appreciation. The return on such stock depends on the volatility or the systematic risk of the stock. The higher the volatility, the higher is the expected rate of return. 

The expected rate of return or, in other words, the cost to compensate the risk for common stock is the highest amongst the other form of financing.

Therefore, bonds usually have the lowest expected rate of return, followed by preferred stock and then common stock.