Question

2.How are preferred stock and common stock similar and different?

1. identify two pros and two cons of each capital budgeting decision rule listed below:
   1. NPV
   2. IRR
   3. Payback Period
   4. AAR

Answer 1

Preferred Stock and common stock similarity
1. Dividends are paid based on the decision by the company.
2. Cost of Dividends and cost of equity are not tax deductible.

Preferred Stock and common stock difference:
1. Common Stock are actual owners whereas preferred stock are not owners in firm.
2. Dividends are paid out in case of both

NPV strengths:
1. it factors in time value of money
2. It includes risk involves in generating cash flow.

Weakness:
1. it is sensitive to discount rate. Faulty calculation of discount rate can distort the results.
2. Cash flow prediction is sometimes subjective leading to variance with actual NPV.

IRR:
Advantages:
1. Includes time value of money.
2. Good in accepting independent projects

Disadvantages
1. Is not good for acceptability with large scale projects where it might be rejected when comparing with small scale project if IRR is higher.
2. IRR and NPV may conflict in certain case where NPV rule Prevails.

Strengths of Payback Period
1. Easy to calculate
2, It less time consuming and followed widly by companies

Weakness:
1. doesn’t consider cash flows after Payback period.
2. It does not include time value of money.

AAR:
1. Easy to calculate as it includes only investment and returns.
2. It is easy to understand and compare between projects.

Weakness:
1. It doesnot use time value of money.
2. It fails to select projects based on scale of project.