General Securities Representative (Series 7) Practice Exam

If a company issues more preferred stock and bonds, what is the net effect on its capital structure?

1. Decreased leverage

2. No effect on leverage

3. Increased equity

4. Increased leverage

The correct answer is: Increased leverage

When a company issues more preferred stock and bonds, this typically leads to an increase in its leverage. Leverage refers to the use of debt and preferred equity to finance a company’s operations and growth. Preferred stock is considered a type of equity, but it has characteristics similar to debt, such as fixed dividends and priority over common stock in the event of liquidation. Issuing bonds represents an increase in long-term debt, and when debt levels rise, financial leverage increases because the company borrows more compared to its equity base. This higher proportion of debt in the capital structure can enhance returns on equity, but it also increases financial risk due to the obligation to pay interest. In summary, by issuing both preferred stock and bonds, the company is effectively raising its total liabilities, which in turn increases its overall leverage. This change in capital structure typically indicates a greater reliance on fixed-cost financing. Such adjustments can impact various financial metrics, signaling a shift toward a more aggressive financial strategy.