Question 18

The cost of capital for common stocks is typically higher than that for preferred stocks or bonds because common stockholders' claims in liquidation come after preferred stockholders and bondholders.

This hierarchy of claims means that common stockholders face greater risk, which is reflected in the higher required return on their investments.

A) Common stock creates tax shields for a company, while preferred stocks and bonds do not.

This option is incorrect because the concept of tax shields primarily applies to debt financing, such as bonds, where interest payments are tax-deductible. Common stock does not create a tax shield, thus this does not explain the difference in cost of capital.

B) Common stockholders' claims in liquidation come after preferred stockholders and bondholders.

This statement is correct. In the event of liquidation, common stockholders are paid only after all debts and preferred stock claims have been satisfied, exposing them to greater risk. This higher level of risk results in a higher cost of capital for common equity compared to preferred stocks and bonds.

C) Common stockholders have first claim in liquidation before preferred stockholders and bondholders.

This option is incorrect as it misrepresents the hierarchy of claims. In reality, common stockholders do not have first claim; rather, they are the last to receive any remaining assets after all other claims are settled, which contributes to the higher cost of capital.

D) Common stock does not create tax shields, while preferred stocks and bonds do.

This statement is misleading. While it is true that common stock does not create tax shields, preferred stocks and bonds do not inherently provide significant tax benefits either. This option does not accurately address the risk associated with common stock in terms of liquidation priorities.

Conclusion

The cost of capital for common stocks is higher primarily due to the increased risk faced by common stockholders, who are last in line during liquidation. This contrasts with the more secure positions of preferred stockholders and bondholders, leading to their lower required returns. Thus, option B accurately captures the essence of the risk-return relationship in capital structure.