Preferred stock

Definition

Preferred stock is a type of equity security that gives shareholders a higher claim on assets and earnings than common stockholders, usually with fixed dividend payments. Unlike common stock, preferred stock typically does not come with voting rights, but it provides a level of income stability due to its priority in dividend distribution and liquidation scenarios, making it an important component in understanding the cost of capital and the calculation of Weighted Average Cost of Capital (WACC).

5 Must Know Facts For Your Next Test

1. Preferred stockholders receive dividends before common stockholders, making it a safer investment during economic downturns.
2. The dividend rate for preferred stock is typically fixed, which can make it attractive for income-seeking investors.
3. In the event of liquidation, preferred shareholders have a claim on assets before common shareholders but after debt holders.
4. Preferred stocks can be convertible, allowing shareholders to exchange them for common stock under certain conditions.
5. The cost of preferred equity is often used in WACC calculations since it represents a source of capital for the company.

Review Questions

• How does preferred stock differ from common stock in terms of risk and returns?
  • Preferred stock generally carries lower risk compared to common stock because preferred shareholders receive fixed dividends before any payments are made to common shareholders. While common stock can provide higher potential returns through capital appreciation, its dividends are not guaranteed, making it riskier. Preferred stock's fixed dividend structure appeals to conservative investors looking for steady income, especially in uncertain market conditions.
• Discuss the role of preferred stock in calculating WACC and how it impacts a company's overall cost of capital.
  • In the calculation of WACC, preferred stock is included as a component of a company's capital structure alongside debt and common equity. Its cost is factored into the overall weighted average based on its market value relative to total capital. This inclusion reflects the obligation to pay fixed dividends to preferred shareholders, thus impacting the overall cost of capital by providing a more accurate picture of the company's financing costs and risk profile.
• Evaluate the strategic advantages and disadvantages of issuing preferred stock as a method of raising capital for companies.
  • Issuing preferred stock can offer companies strategic advantages, such as attracting investors who seek stable income through fixed dividends without diluting control since preferred shares typically do not carry voting rights. However, there are disadvantages too; for instance, companies must commit to paying these dividends regardless of financial performance, which could strain cash flow during downturns. Additionally, having too much preferred stock can increase the overall cost of capital, complicating financing strategies and impacting future funding opportunities.

Related terms

common stock: Common stock represents ownership in a company and usually comes with voting rights, but dividends are not guaranteed and can vary.

dividend yield:

Dividend yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price.

cost of equity: Cost of equity is the return that investors require on their investment in a company’s equity, often calculated using the Capital Asset Pricing Model (CAPM).