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304 Corporate Finance BRILLIANT’S

Preference dividend is fixed and known, and {S>{dS>oÝS> {’$³ñS> VWm kmV hmoVm h¡ ’$‘© BgH$m ^wJVmZ
the firm will pay it after paying interest but {H$gr Am°{S>©Zar {S>{dS>oÝS> Ho$ ^wJVmZ Ho$ nhbo bo{H$Z BÝQ>aoñQ>
before paying any ordinary dividend, because Ho$ ^wJVmZ Ho$ ~mX H$aoJr& ³¶m|{H$ {à’$aoÝg {S>{dS>oÝS BÝQ>aoñQ>
preference dividend is subordinate to interest, na {Z^©a hmoVm h¡, {n«’$aoñQ> H¡${nQ>b S>oãQ> go A{YH$ [añH$s
preference capital is more risky than debt.
Ordinary shareholders supply capital either hmoVm h¡& Am°{S>©Zar eo¶ahmoëS>g© [aQ>oÝS> A{Zª½g AWdm ZE
in the form of retained earnings or by eo¶g© H$s IarXr Ho$ ê$n ‘| H¡${nQ>b gßbm¶ H$aVo h¢&
purchasing new shares. Unlike creditors, they BgHo$ {dnarV H«o${S>Q>g© ’$‘© Ho$ Am°Zg© hmoVo h¡ VWm AnZo
are owners of the firm and retain its control. H§$Q´>mob H$mo ~ZmE aIVo h¢& do ‘¡ZoO‘|Q> H$mo CZH$s Va’$ go
They delegate powers to management to make BÝdoñQ>‘|Q> {S>grOZ boZo H$s ep³V XoVo h¢ ‘¡ZoO‘|Q> Bg
investment decisions on their behalf in such a àH$ma Ho$ {S>grOZ boVm h¡ {Oggo H«o${S>Q>g© H$s d¡ëW
way that their wealth is maximized. However,
‘op³g‘mBO hmo& hmbm§{H$, Am°{S>©Zar eo¶ahmoëS>g© eof AgoQ²>g
ordinary shareholders have claim on the
residual assets and cash flows. The payment of VWm H¡$e âbmo na ³bo‘ H$aVo h¢& Am°{S>©Zar eo¶ahmoëS>g©
ordinary dividend is discretionary. Ordinary H$m no‘|Q> {ddoH$mYrZ hmoVm h¡& Am°{S>©Zar eo¶ahmoëS>g© H$mo,
shareholders may be paid dividends from cash BÝQ>aoñQ> VWm {à’$aoÝg {S>{dS>oÝS²>g Ho$ ^wJVmZ Ho$ ~mX eof
remaining after interest and preference ~Mo H¡$e go {S>{dS>oÝS²>g H$m ^wJVmZ {H$¶m Om gH$Vm h¡&
dividends have been paid. Also, the market
Am°{S>©Zar eo¶g© H$s ‘mH}$Q> àmBO ‘| {à’$aoÝg eo¶g© VWm
price of ordinary share fluctuates more widely
S>oãQ> go A{YH$ CVma M‹T>md hmoVo h¢& Bg àH$ma Am°{S>©Zar
than that of the preference share and debt.
Thus, ordinary share is more risky than both eo¶g©, S>oãQ> VWm {à’$aoÝg eo¶g© go A{YH$ [añH$s hmoVo h¢&
preference share and debt. Various forms of H$m°nm}aoQ> S>oãQ> Ho$ {d{^ÝZ ’$m°åg© H$mo CZHo$ [añH$Zog Ho$
corporate debt can also be distinguished in AmYma na {d^m{OV {H$¶m Om gH$Vm h¡& ¶{X h‘ H$m°nm}aoQ>
terms of their differential risk. If we compare
~m°ÊS> VWm JdZ©‘|Q> ~m°ÊS> H$s VwbZm H$a| Vmo JdZ©‘|Q> ~m°ÊS>
corporate bonds and government bonds, the
later are less risky since it is very unlikely that H$‘ [añH$s hmoVo h¢& ³¶m|{H$ ¶h g§^mdZm ~hþV H$‘ h¡ {H$
the government will default in its obligation to JdZ©‘|Q> BÝQ>aoñQ> VWm qà{gnb Ho$ ^wJVmZ ‘| {S>’$mëQ>
pay interest and principal. H$aoJr&
Risk Differences [añH$ ‘| A§Va

Investors will require different rates of BÝdoñQ>g© {d{^ÝZ {g³¶w[aQ>rO ‘| AbJ-AbJ aoQ>
return of various securities since they have risk Am°’$ [aQ>Z© MmhVo h¢ Bg{bE CZHo$ [añH$ ‘| ^r A§Va hmoVo
differences. Higher the risk of a security, the h¡& BÝdoñQ>g© Ûmam aoQ> Am°’$ [aQ>Z© A{YH$ hmoZo na {g³¶w[aQ>r
higher is the rate of return demanded by na [añH$ ^r A{YH$ hmoVr h¡& My§{H$ Am°{S>©Zar eo¶g© Á¶mXm
investors. Since ordinary shares are most risky,
investors will require highest rate of return on [añH$s hmoVo h¢ ³¶m|{H$ BÝdoñQ>g© AnZo BÝdoñQ>‘|Q> na A{YH$
aoQ> Am°’$ [aQ>Z© MmhVo h¢& {à’$aoÝg eo¶a S>oãQ> go A{YH$
their investments. Preference share is more
risky than debt, therefore, its required rate of [añH$s hmoVo h¢ Bg{bE BZH$s [a³dm¶S>© aoQ> Am°’$ [aQ>Z© ^r
return, will be higher than that of debt. The S>oãQ go A{YH$ hmoJr& BgH$m [añH$ àr{‘¶‘ ^r A{YH$
higher will be its risk premium, and therefore, hmoJm, Bgr{bE, BgH$m [a³dm¶S>© aoQ> Am°’$ [aQ>Z© ^r A{YH$
a higher required rate of return. hmoJm&