Preferred Stock

Definition

Preferred stock is a type of equity security that gives shareholders a higher claim on assets and earnings than common stockholders. This means preferred stockholders receive dividends before common stockholders and often have a fixed dividend rate, providing a level of predictability in returns. Preferred stock can also include features like convertibility into common shares or redemption rights, which adds to its appeal in corporate capital structure.

5 Must Know Facts For Your Next Test

1. Preferred stock typically has a fixed dividend rate, providing a more stable income compared to the variable dividends of common stock.
2. In the event of liquidation, preferred stockholders have priority over common stockholders when it comes to asset distribution.
3. Some preferred stocks come with conversion rights, allowing holders to convert their shares into a specified number of common shares, often at a predetermined price.
4. Preferred stock can be cumulative, meaning if a company misses a dividend payment, it must pay those dividends before paying any to common stockholders.
5. The issuance of preferred stock can help companies raise capital without diluting the voting power of existing common shareholders.

Review Questions

• How does preferred stock compare to common stock in terms of dividends and claims on assets?
  • Preferred stockholders have a higher claim on both dividends and assets than common stockholders. This means that preferred dividends are paid before any dividends are distributed to common shareholders. In the case of liquidation, preferred stockholders also get paid first when assets are distributed. This hierarchy makes preferred stock a safer investment compared to common stock, but it typically lacks voting rights.
• Discuss how the features of preferred stock can impact a company's capital structure decisions.
  • The inclusion of preferred stock in a company's capital structure allows for greater flexibility in financing. It provides an opportunity to raise capital without affecting the voting power of existing shareholders while still offering fixed returns to investors. Companies can strategically use preferred stock to balance their debt-to-equity ratio and manage financial risk. Moreover, the potential for convertible features can attract more investors by offering them an option for future equity participation.
• Evaluate the implications of issuing cumulative versus non-cumulative preferred stock for both investors and companies.
  • Issuing cumulative preferred stock benefits investors because any missed dividend payments must be paid before any distributions to common shareholders can occur, creating a safety net for them. For companies, however, this means they carry an obligation to pay back these missed dividends, which could strain cash flow during tough financial periods. In contrast, non-cumulative preferred stock does not require missed dividends to be paid in arrears, offering companies more flexibility but less security for investors. This trade-off impacts investor confidence and may affect the cost of capital for the company.

Related terms

Common Stock: Common stock represents ownership in a corporation and entitles shareholders to vote at shareholder meetings and receive dividends, although these are not guaranteed.

Dividends:

Dividends are payments made by a corporation to its shareholders, usually as a distribution of profits, and can be issued in cash or additional shares.

Capital Structure: Capital structure refers to the mix of debt and equity that a company uses to finance its operations and growth, influencing the overall risk and return for investors.