Based on the following case study, Is preferred stock more risky than common stock? Please explain in a detailed fashion to help me better understand.

CASE Study

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 firms 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. Chapter 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 829Because 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 firms 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 Duncans assistant, you have been asked to help in the decision process by an-swering the following questions. a. How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock? b. How can knowledge of call options help a financial manager to better understand warrants and convertibles? c. Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and focus on the others. EduSofts investment banker estimates that EduSoft could issue a bond-with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a strike price of $25 and 10 years until expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%.(1) What coupon rate should be set on the bond with warrants if the total package is to sell at par ($1,000)?(2) When would you expect the warrants to be exercised? What is a stepped-up ex-ercise price?(3) Will the warrants bring in additional capital when exercised? If EduSoft issues 100,000 bond-with-warrant packages, how much cash will EduSoft receive when the warrants are exercised? How many shares of stock will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding.)(4) Because the presence of warrants results in a lower coupon rate on the accompa-nying debt issue, shouldnt all debt be issued with warrants? To answer this, esti-mate the anticipated stock price in 10 years when the warrants are expected to be exercised, and then estimate the return to the holders of the bond-with-warrants packages. Use the corporate valuation model to estimate the expected stock price in 10 years. Assume that EduSofts current value of operations is $500 million and it is expected to grow at 8% per year.(5) How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock (which is 13.4%)?(6) If the corporate tax rate is 25%, what is the after-tax cost of the bond with warrants? d. As an alternative to the bond with warrants, Mr. Duncan is considering convertible bonds. The firms investment bankers estimate that EduSoft could sell a 20-year, 8.5% coupon (paid annually), callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 10% coupon (paid annually). The convertibles would be call protected for 5 years, the call price would be $1,100, and the company would probably call the bonds as soon as possible after their conversion value exceeds $1,200. Note, though, that the call must occur on an issue-date anniversary. EduSofts current stock price is $20, its last dividend was $1, and the dividend is expected to grow at a constant 8% rate. The convertible could be converted into 40 shares of EduSoft stock at the owners option.(1) What conversion price is built into the bond?(2) What is the convertibles straight-debt value? What is the implied value of the convertibility feature?

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 firms 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.