Preferred Stock

Definition

Preferred stock is a type of equity security that typically provides shareholders with preferential treatment when it comes to dividends and asset distribution in the event of liquidation. This means preferred shareholders receive their dividends before common shareholders and have a higher claim on assets, which makes it an attractive investment for those seeking stable income. Unlike common stock, preferred stock generally does not carry voting rights, making it a unique choice for investors looking to balance risk and return.

5 Must Know Facts For Your Next Test

1. Preferred stock can be cumulative or non-cumulative; cumulative preferred stock requires that any unpaid dividends be paid out before any dividends are distributed to common shareholders.
2. Some preferred stocks are convertible, allowing investors to exchange their shares for a predetermined number of common shares at a set price, providing potential for capital appreciation.
3. Preferred stock may have a fixed dividend rate, which can offer more stability than common stocks, but typically does not offer the same growth potential.
4. In the event of bankruptcy, preferred stockholders rank above common stockholders but below debt holders when it comes to claims on assets.
5. Companies may issue preferred stock as a way to raise capital without diluting the control of existing common shareholders since preferred shares usually do not carry voting rights.

Review Questions

• How does the structure of preferred stock influence its attractiveness to certain investors compared to common stock?
  • The structure of preferred stock, with its fixed dividends and higher claim on assets during liquidation, makes it particularly attractive to income-focused investors who seek steady returns with less risk. While common stock may offer growth potential and voting rights, preferred stock provides stability through predictable dividend payments and priority in asset claims. This balance appeals to those who prioritize income over control in corporate governance.
• Discuss the implications of cumulative versus non-cumulative preferred stock for investors during periods of financial distress.
  • Cumulative preferred stock has significant implications for investors during financial distress because it ensures that any missed dividend payments must be paid before any distributions are made to common shareholders. This feature protects investors by accumulating owed dividends, providing a sense of security even when a company faces challenges. In contrast, non-cumulative preferred stock does not offer this protection, meaning missed dividends do not accumulate, potentially leading to loss of income during tough times.
• Evaluate how the issuance of preferred stock affects a company's capital structure and its overall financial strategy.
  • The issuance of preferred stock plays a crucial role in a company's capital structure by providing an alternative financing option that allows for raising capital without diluting control through voting rights associated with common stock. This can enhance the financial strategy by enabling companies to secure funds while managing their equity base efficiently. Additionally, since preferred dividends are often fixed and do not have to be paid in times of loss, it allows companies greater financial flexibility compared to debt financing, which imposes mandatory interest payments.

Related terms

Common Stock:

A type of equity security that represents ownership in a company and usually comes with voting rights, allowing shareholders to influence corporate governance.

Dividend: A portion of a company's earnings distributed to shareholders, typically paid out in cash or additional shares, with preferred stockholders often receiving fixed dividends.

Liquidation Preference: The order in which claims are paid in the event of a company's liquidation, where preferred stockholders are prioritized over common stockholders.