Preferred Stock

Definition

Preferred stock is a type of equity security that typically provides shareholders with fixed dividends before any dividends are paid to common stockholders. It combines features of both debt and equity, offering priority in the event of liquidation and often having no voting rights. This security is important in assessing a company's capital structure, especially regarding risk-weighted assets and capital components.

5 Must Know Facts For Your Next Test

1. Preferred stockholders have a higher claim on assets and earnings than common stockholders, making it a safer investment option.
2. The fixed dividend payment of preferred stock can be cumulative or non-cumulative; cumulative preferred stock accumulates unpaid dividends.
3. Preferred stock often has features such as convertibility into common shares or callability by the issuer, giving it unique characteristics.
4. In terms of capital components, preferred stock is generally classified between debt and equity on a company's balance sheet, affecting risk-weighted asset calculations.
5. When evaluating a financial institution's capital adequacy, regulators often consider the level of preferred stock as part of total capital.

Review Questions

• How does preferred stock affect a company's capital structure compared to common stock?
  • Preferred stock impacts a company's capital structure by providing a layer of security for investors due to its priority over common stock during dividend payments and liquidation. Unlike common stock, which is more volatile and carries voting rights, preferred stock offers fixed dividends and often lacks voting power. This distinction makes preferred stock an appealing choice for risk-averse investors while also allowing companies to raise capital without diluting control over shareholder votes.
• Discuss the implications of cumulative versus non-cumulative preferred stock for investors.
  • Cumulative preferred stock guarantees that any unpaid dividends will accumulate and must be paid before dividends can be distributed to common shareholders. This feature provides investors with an added layer of protection and potential compensation for missed payments. In contrast, non-cumulative preferred stock does not accumulate unpaid dividends, meaning if a company skips a dividend payment, investors may never recover those missed dividends, which increases risk for those holding such shares.
• Evaluate the role of preferred stock in managing risk-weighted assets for financial institutions.
  • Preferred stock plays a crucial role in managing risk-weighted assets for financial institutions by contributing to total capital while being viewed more favorably than common equity during regulatory assessments. Since it ranks higher than common equity in terms of claims on assets during liquidation but lower than debt obligations, it provides a balance that can enhance leverage ratios. As regulators scrutinize capital adequacy, the presence of preferred stock can help banks meet minimum capital requirements while still maintaining sufficient liquidity, ultimately influencing their overall risk profile.

Related terms

Common Stock: Common stock represents ownership in a company and usually comes with voting rights, but it is subordinate to preferred stock in terms of dividend payments and liquidation proceeds.

Dividends: Dividends are payments made by a corporation to its shareholders, typically derived from profits, with preferred stockholders receiving theirs before common stockholders.

Equity Financing: Equity financing refers to the method of raising capital through the sale of shares, which can include both preferred and common stock, impacting a company's capital structure.