Debt versus Preferred Stock Assume that you are an analyst attempting to compare the fi nancial structures of two companies. In particular, you must analyze the debt and equity categories of the two fi rms and calculate a debt-to-equity ratio for each fi rm. The Liability and Equity categories of First Company at year-end appeared as follows:

Liabilities Accounts payable $ 500,000 Loan payable 800,000 Stockholders’ Equity Common stock 300,000 Retained earnings 600,000 Total liabilities and equity $2,200,000 First Company’s loan payable bears interest at 8%, which is paid annually. The principal is due in fi ve years.

The Liability and Equity categories of Second Company at year-end appeared as follows:

Liabilities Accounts payable $ 500,000 Stockholders’ Equity Common stock 300,000 Preferred stock 800,000 Retained earnings 600,000 Total liabilities and equity $2,200,000 Second Company’s preferred stock is 8%, cumulative. A provision of the stock agreement specifi es that the stock must be redeemed at face value in fi ve years.

Required 1. It appears that the loan payable of First Company and the preferred stock of Second Company are very similar. What are the differences between the two securities?

2. When calculating the debt-to-equity ratio, do you believe that the Second Company preferred stock should be treated as debt or as stockholders’ equity?

Write a statement expressing your position on the issue.

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