Preferred shares

Definition

Preferred shares are a type of equity security that provides shareholders with preferential rights over common shareholders in terms of dividends and asset distribution during liquidation. These shares typically have fixed dividend rates, which must be paid out before any dividends are distributed to common shareholders, making them less risky compared to common stock.

5 Must Know Facts For Your Next Test

1. Preferred shares usually come with a fixed dividend that is paid out regularly, providing more stable income compared to common shares.
2. In the event of liquidation, preferred shareholders are prioritized over common shareholders when it comes to asset distribution.
3. Some preferred shares may be convertible into common shares, allowing shareholders to benefit from potential appreciation in stock value.
4. Preferred shares often do not carry voting rights, meaning preferred shareholders typically cannot vote on company matters like common shareholders can.
5. The market price of preferred shares can fluctuate based on interest rates; when rates rise, the value of existing preferred shares often decreases.

Review Questions

• How do preferred shares differ from common shares in terms of dividends and voting rights?
  • Preferred shares differ from common shares primarily in their dividend structure and voting rights. Preferred shareholders receive fixed dividends that must be paid before any dividends are given to common shareholders, offering them more predictable income. However, preferred shares generally do not provide voting rights, meaning holders have no say in company governance, unlike common shareholders who can vote on important corporate matters.
• Discuss the advantages and disadvantages of investing in preferred shares compared to common shares.
  • Investing in preferred shares comes with both advantages and disadvantages. The key advantage is the fixed dividend income and priority during liquidation, providing a layer of security. On the downside, preferred shareholders usually lack voting rights and might miss out on capital gains if the company performs exceptionally well since their potential for appreciation is often limited compared to common stock. This makes preferred shares suitable for conservative investors looking for stable income rather than growth.
• Evaluate how the characteristics of preferred shares influence their market behavior compared to other equity securities.
  • The characteristics of preferred shares significantly influence their market behavior, particularly their sensitivity to interest rates. Since they offer fixed dividends, when interest rates rise, new issues may become more attractive, leading to a decrease in the market value of existing preferred shares. Additionally, their lack of voting rights and priority in dividends can make them less appealing to investors looking for growth or influence within the company. Understanding these dynamics is crucial for investors aiming to balance risk and return in their equity portfolio.

Related terms

dividend: A portion of a company's earnings that is distributed to shareholders, typically on a regular basis, based on the number of shares they own.

common shares: A type of equity security that represents ownership in a company, giving shareholders voting rights and a residual claim on assets after all debts and preferred dividends have been paid.

liquidation preference: The order in which different classes of shareholders are paid in the event of a company's liquidation, with preferred shareholders typically receiving their investment back before common shareholders.