Question

Supposed a company has a preferred stock issue and a common stock issue. Both have just paid a $2 dividend. Do you think the price will be the same? Explain?

Answer 1

No, the price is dependent on required return and growth rate

Price=Last Dividend*(1+growth rate)/(required return-growth rate)

For preferred stock, growth rate is zero as dividend is fixed and as dividend is fixed,it is less risky and hence required return is lower than common stock.

But for common stock, the difference will arise due to interplay between growth rate and required return.

If (1+growth rate)/(required return on common stock-growth rate)>1/required return on preferred stock

Then price of common stock will be higher than price of preferred stock even though they paid the same last dividend.