Preferred stock

Definition

Preferred stock is a type of equity security that gives shareholders preferential treatment in the payment of dividends and in the event of liquidation. Holders of preferred stock typically receive fixed dividends before any dividends are paid to common stockholders, and they often have priority over common stockholders for assets in the event the company is dissolved. This makes preferred stock an attractive option for investors seeking income with less risk compared to common stock.

5 Must Know Facts For Your Next Test

1. Preferred stock often has a fixed dividend rate, which can make it appealing for investors looking for steady income.
2. Preferred shareholders usually do not have voting rights in corporate decisions, unlike common shareholders.
3. In liquidation scenarios, preferred stockholders get paid before common stockholders, but after debt holders.
4. Some preferred stocks come with convertibility options, allowing investors to convert them into common shares under certain conditions.
5. Preferred stock can be cumulative or non-cumulative; cumulative preferred stocks entitle shareholders to unpaid dividends in the future, while non-cumulative stocks do not.

Review Questions

• How does preferred stock differ from common stock in terms of shareholder rights and benefits?
  • Preferred stock differs from common stock mainly in the treatment of dividends and rights regarding company assets. Preferred shareholders receive fixed dividends that are prioritized over those of common shareholders and have a claim on assets during liquidation before common stockholders. However, preferred shareholders typically do not have voting rights in corporate matters, which is a key benefit of holding common stock.
• What are the implications of a company's decision to issue preferred stock instead of debt or common equity?
  • Issuing preferred stock allows a company to raise capital without diluting ownership control as much as issuing common stock would. It provides a way to attract income-focused investors who prefer fixed returns over potential growth. However, it also means committing to regular dividend payments, which could strain finances if cash flows are unstable. This choice reflects the company's strategy in balancing equity financing and financial obligations.
• Evaluate the advantages and disadvantages of investing in preferred stock compared to other investment vehicles, like bonds or common equity.
  • Investing in preferred stock offers advantages like priority for dividends and claims on assets during liquidation, making it less risky than common equity. It typically provides higher yields than bonds due to its hybrid nature between debt and equity. However, it lacks voting rights and may have less potential for capital appreciation compared to common shares. Thus, while preferred stocks provide steady income, they might limit growth opportunities that come with common equity investments.

Related terms

dividends: Payments made by a corporation to its shareholders, usually in the form of cash or additional shares, representing a portion of the company's earnings.

common stock:

A type of security that represents ownership in a company and typically comes with voting rights, but dividends are not guaranteed.

liquidation preference: The order of payment to different classes of investors in the event a company is liquidated, determining who gets paid first.