CFA Practice Question

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CFA Practice Question

A company presents its financial statements according to U.S. GAAP and has just issued $5 million of mandatory redeemable preferred shares with a par value of $100 per share and a 7% dividend. The issue matures in 5 years. Which of the following statements is least likely correct? At the time of the issue, the company's ______
A. debt-to-total-capital ratio will improve.
B. interest coverage ratio will deteriorate.
C. preferred shareholders will rank below debt-holders should the company file for bankruptcy.
Explanation: SFAS 150 requires that issuers report as liabilities any financial instruments that will require repayment of principal in the future. Mandatory redeemable preferred shares must be reported as debt; dividends on such stock must be reported as interest expense (consistent with the view that the preferred stock is debt), which will lower the interest coverage ratio.

In the Debt/(Debt + Equity) ratio, the Debt will increase making the debt/total capital increase (the numerator will increase more than the denominator); thus, the ratio will increase (deteriorate), not decrease (improve).

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