Preferred stock

Definition

Preferred stock is a type of equity security that provides shareholders with preferential treatment in terms of dividend payments and asset distribution during liquidation. Unlike common stockholders, preferred shareholders typically receive fixed dividends before any dividends are paid to common stockholders, making it a hybrid between equity and debt instruments. This feature connects preferred stock to capital structure decisions and financial statement analysis, especially when evaluating a company's cost of capital and its implications for financial stability.

5 Must Know Facts For Your Next Test

1. Preferred stock often comes with a fixed dividend rate, which makes it appealing for income-focused investors seeking regular cash flow.
2. In the event of liquidation, preferred shareholders have a higher claim on assets than common shareholders but lower than creditors.
3. Some preferred stocks have conversion features that allow them to be converted into a predetermined number of common shares under specific conditions.
4. Preferred stock can be cumulative, meaning if dividends are not paid in one year, they accumulate and must be paid in the future before any dividends can be distributed to common stockholders.
5. The cost of preferred stock is typically lower than that of debt due to its risk profile but higher than the cost of common equity since it has a fixed dividend obligation.

Review Questions

• How does preferred stock influence a company's capital structure and financial strategy?
  • Preferred stock influences a company's capital structure by providing a source of financing that blends features of both debt and equity. Companies can issue preferred stock to raise capital without diluting the voting power of common shareholders. This allows for greater flexibility in financial strategy, particularly in managing cash flows since fixed dividends may be less burdensome during periods of lower earnings compared to mandatory interest payments on debt.
• Discuss the implications of preferred stock's dividend payment structure for investors during economic downturns.
  • The dividend payment structure of preferred stock can have significant implications for investors, especially during economic downturns. Since preferred shareholders receive their dividends before common shareholders, they have a more secure income stream even when the company faces financial challenges. However, if a company suspends dividend payments due to severe financial strain, preferred shareholders may still experience losses since their dividends are only accumulated rather than guaranteed, which affects investor confidence and market perception.
• Evaluate how the features of preferred stock affect its attractiveness as an investment compared to common stock and corporate bonds.
  • The features of preferred stock make it an attractive investment option for certain investors seeking income while balancing risk. Unlike common stock, preferred stock offers fixed dividend payments and priority in asset claims upon liquidation, which provides some level of security. Compared to corporate bonds, preferred stock typically carries more risk due to its equity nature but may offer higher potential returns through capital appreciation. An investor’s decision between these options will depend on their risk tolerance, income needs, and market conditions.

Related terms

dividend: A payment made by a corporation to its shareholders, typically from profits, often expressed as a fixed amount per share.

common stock:

A type of security that represents ownership in a corporation and entitles the shareholder to vote on corporate matters and receive dividends after preferred stockholders.

capital structure: The mix of debt and equity that a company uses to finance its operations and growth.