Preferred stock

Definition

Preferred stock is a type of equity security that provides shareholders with a fixed dividend before any dividends are paid to common stockholders. It typically comes with preferential treatment regarding dividends and asset liquidation, meaning preferred shareholders get paid first in case of company liquidation. This stock often does not carry voting rights, but it offers stability and a fixed income, making it appealing for risk-averse investors.

5 Must Know Facts For Your Next Test

1. Preferred stock often has a set dividend rate that is usually higher than common stock dividends, providing more predictable income for investors.
2. It can be cumulative or non-cumulative; cumulative preferred stock accumulates unpaid dividends while non-cumulative does not.
3. Preferred shares may be convertible into common shares, giving investors potential for capital appreciation if the company's value increases.
4. Unlike common stocks, preferred stockholders typically do not have voting rights in corporate governance matters.
5. Preferred stock can be callable, meaning the company has the right to repurchase the shares at a predetermined price after a certain date.

Review Questions

• How does preferred stock provide advantages to investors compared to common stock?
  • Preferred stock offers several advantages over common stock, primarily through its fixed dividend payments that are prioritized over those of common stockholders. This provides a more stable income stream for investors, particularly in volatile markets. Additionally, preferred shareholders have a higher claim on assets during liquidation events, meaning they are less likely to lose their investment compared to common shareholders.
• Discuss the implications of cumulative versus non-cumulative preferred stock for investors and companies.
  • Cumulative preferred stock benefits investors by ensuring that any unpaid dividends accumulate and must be paid out before common dividends are distributed. This gives investors more security regarding their income. On the other hand, non-cumulative preferred stock allows companies greater flexibility since they can skip dividend payments without the obligation to pay them later. This can be advantageous for companies facing cash flow challenges but poses a risk to investors who may lose expected income.
• Evaluate how the features of preferred stock can affect a company's capital structure and overall financial strategy.
  • The inclusion of preferred stock in a company's capital structure can provide advantages such as lower cost of capital and reduced dilution of ownership when compared to issuing more common shares. Companies may use preferred stock to attract risk-averse investors while preserving cash flow, as dividends are often fixed. Furthermore, by carefully managing the mix between debt and preferred equity, companies can optimize their financial leverage, ultimately affecting their financial strategy and growth potential.

Related terms

common stock:

Common stock represents ownership in a company and comes with voting rights, allowing shareholders to influence corporate decisions, but it carries higher risk regarding dividend payments.

dividend: A dividend is a portion of a company's earnings distributed to shareholders, usually in cash or additional shares, serving as a reward for investing.

liquidation preference: Liquidation preference is the order in which investors are paid back their investments in the event of a company's liquidation, with preferred shareholders receiving payment before common shareholders.