Dividend preference

Definition

Dividend preference refers to the priority given to preferred shareholders over common shareholders when it comes to the distribution of dividends. This means that preferred shareholders are entitled to receive their dividends before any dividends are paid to common shareholders, ensuring they have a more reliable income stream from their investment. This preference is a key characteristic of preferred stock and highlights the different rights and privileges between preferred and common equity holders.

5 Must Know Facts For Your Next Test

1. Preferred shareholders usually receive fixed dividends that are paid out regularly, making their investments less risky compared to common shares.
2. If a company faces financial difficulties and can only pay partial dividends, preferred shareholders are prioritized, and common shareholders may not receive any dividends at all.
3. Some preferred stocks come with a cumulative feature, meaning any unpaid dividends must be paid out before common stockholders can receive dividends.
4. In the case of liquidation, preferred shareholders have a higher claim on assets than common shareholders, which provides an additional layer of security for their investment.
5. Dividends can be suspended or reduced by companies without affecting their obligation to pay preferred shareholders their owed amounts in the future, especially if they hold cumulative preferred shares.

Review Questions

• How does dividend preference impact the investment decision between common and preferred stocks?
  • Dividend preference is a crucial factor for investors when choosing between common and preferred stocks. Investors seeking stable income may prefer preferred stocks due to their priority in dividend payments, which can provide more predictable cash flow. In contrast, those looking for growth potential may opt for common stocks, which have higher volatility and potential for capital appreciation but come with the risk of receiving no dividends during tough financial times.
• Evaluate how dividend preference influences a company's dividend policy and its implications for shareholder relations.
  • Dividend preference shapes a company's overall dividend policy as management must balance the need to satisfy preferred shareholders with maintaining sufficient earnings for reinvestment and paying dividends to common shareholders. This relationship can lead to tensions among investors if common shareholders feel neglected during lean times. Companies might also be careful about declaring dividends if they lack sufficient cash flow since failing to pay preferred dividends could signal financial distress and negatively impact the company's reputation.
• Assess the long-term effects of having a significant amount of preferred stock on a company's capital structure and its ability to raise funds in the future.
  • Having a substantial amount of preferred stock can create challenges for a company's capital structure by increasing fixed financial obligations due to mandatory dividend payments. This can limit the company's flexibility in managing cash flow and restrict its ability to reinvest earnings into growth opportunities. Additionally, if investors perceive high levels of preferred stock as a sign of financial instability or risk, it may hinder the company's ability to attract new investors or secure favorable financing terms in future capital raises.

Related terms

Preferred Stock:

A class of stock that typically gives shareholders priority over common stockholders when it comes to dividends and assets in the event of liquidation.

Common Stock: A class of stock that represents ownership in a company and typically comes with voting rights, but shareholders are last in line for dividends and assets upon liquidation.

Dividend Declaration: The formal announcement made by a company's board of directors stating the amount of dividend to be paid to shareholders on a specific date.