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...

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 firm’s 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.

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 firm’s 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 Duncan’s assistant, you have been asked to help in the decision process by

answering 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?