Are the answers correct?
Are the answers correct?
Hi @EdwarDallas! Thanks for reaching out about these questions. Both questions are correct, but maybe a different explanation will help.
FYI - we have multiple versions of this question with different numbers, so the question quoted below may seem slightly different than the one you saw. Regardless, the format will be exactly the same:
ABC Company $50 par, 6% preferred shares are trading in the market at $54. Which of the following statements is true?
A)The current yield is 6%
B)The 6% dividend rate is based on the $50 par value
C) An investor will receive $3.00 per dividend payment
D) All of these choices
Let’s break down the three wrong answers, then discuss the correct one. Answer choice A is incorrect because the current yield is 5.55%. The current yield is found by dividing the annual income (6% of $50 = $3 annual income) by the market value ($54). $3 / $54 = 5.55%. You may have confused the current yield with the dividend rate (coupon or nominal rate), which is 6%.
Answer choice C is incorrect because the preferred stock pays $1.50 every dividend payment. The annual income can be calculated by multiplying the dividend rate (6%) by the par value ($50), which is $3. Unless otherwise stated, you should assume preferred shares make semi-annual (twice a year) dividend payments. To total $3 annual income over two payments, the issuer must be paying $1.50 per dividend payment.
Answer choice D is obviously incorrect because of answer choices A and C.
Answer choice B is correct because this accurately states how the dividend rate works. A preferred stock’s dividend rate (6% in this question) is always based on its par value ($50 in this question).
Same thing with this question - likely different numbers, but same format:
An investor is considering the purchase of the following security:
$100 par, 9% participating preferred stock yielding 8%
Which statement is false regarding this security?
A) These shares pay a fixed $9.00 per share in annual dividends regardless of the issuer’s profitability
B) The yield indicates a market price below par
C) A similar issue without the participating feature would likely have a lower yield
D) All of these statements
A, B, and C are all false, which is why D is the best answer. Let’s go through each. Answer choice A is tricky, but false because of the participating feature. 9% is the dividend rate, which will result in $9 in dividends paid per share (9% x $100 par value). However, it’s the end of the answer that makes it incorrect. Participating shares are eligible for higher dividend payments if the issuer has a profitable year. Therefore, stating these shares would make $9 in dividends regardless of the issuer’s profitability is false.
Answer choice B is false because the preferred stock’s yield is lower than its dividend rate. The yield (think current yield) reflects an income-producing security’s overall rate of return, which includes both the dividends paid and the market price. The only way preferred stock can reflect a yield (8%) below its dividend rate (9%) is if the bond is trading at a price above par (a premium). You can test this theory out - let’s assume the stock is trading at $105. Assuming an annual dividend payment of $9, the preferred stock would reflect a current yield of 8.57% ($9 / $105). You can replace $105 with any number above $100 and you’ll always get a yield below 9%. Bottom line - preferred shares with yields below their dividend rate must be trading at a price above par (and vice versa). This chapter is a good refresher on this topic if it still isn’t clear.
Answer choice C is a bit counter-intuitive, but it is false. Participating features are beneficial features to investors. Therefore, preferred shares without this feature reflect lower demand, resulting in lower market prices. Lower market prices mean securities have higher yields. This topic is similar to what we discussed with answer choice B, and I recommend re-reading the chapter linked above if this explanation didn’t solve it for you.
Obviously, this leaves answer choice D as the correct answer.
I hope this helps! Please let me know if you have any questions.
Thank you, Brandon!