Preferred Stock

Definition

Preferred stock is a type of equity security that has a higher claim on assets and earnings than common stock, often featuring fixed dividends that must be paid before dividends to common shareholders. It provides investors with certain advantages such as priority in dividend payments and liquidation, making it an attractive option for those seeking a more stable income stream. Preferred stock can be seen as a hybrid between debt and equity, appealing to investors looking for security with potential upside.

5 Must Know Facts For Your Next Test

1. Preferred stockholders usually receive fixed dividends, which are set at issuance and can be cumulative, meaning unpaid dividends accumulate until paid.
2. In the event of bankruptcy or liquidation, preferred stockholders are paid before common stockholders but after debt holders.
3. Preferred stock may have conversion features that allow holders to convert their shares into common stock under certain conditions.
4. Unlike common stock, preferred stock generally does not provide voting rights to its holders.
5. Different classes of preferred stock may exist within a company, each with distinct rights and privileges regarding dividends and liquidation.

Review Questions

• How does preferred stock differ from common stock in terms of claims on assets and dividend payments?
  • Preferred stock differs from common stock primarily in its claim on assets and dividend payments. Preferred shareholders have a higher claim on assets during liquidation than common shareholders, meaning they get paid first if the company goes bankrupt. Additionally, preferred stock typically comes with fixed dividends that must be paid before any dividends are distributed to common shareholders. This makes preferred stock a safer investment option for those looking for steady income.
• Discuss the implications of cumulative dividends for preferred stockholders and how this affects their investment strategy.
  • Cumulative dividends mean that if a company misses a dividend payment for its preferred shares, those unpaid dividends accumulate until they are paid out. This characteristic gives preferred shareholders an extra layer of security because it ensures they will eventually receive their owed payments before any dividends are paid to common shareholders. This feature can significantly influence an investor's strategy by making preferred stocks an appealing option for those who prioritize reliable income and lower risk.
• Evaluate the role of preferred stock in a company's capital structure and how it affects both the company’s financial flexibility and investor appeal.
  • Preferred stock plays a unique role in a company's capital structure by providing a source of financing that sits between debt and equity. It allows companies to raise capital without diluting control since preferred shareholders typically do not have voting rights. This can enhance financial flexibility as companies can issue preferred shares during times when they want to avoid incurring more debt. For investors, preferred stock offers the advantage of fixed returns with less risk than common equity, making it attractive for income-focused portfolios while still allowing companies to leverage their equity without increasing debt levels.

Related terms

Common Stock: A type of equity security that represents ownership in a company, giving shareholders voting rights and the potential for dividends, but with lower priority than preferred stock in terms of claims on assets.

Dividends: Payments made by a corporation to its shareholders, typically derived from profits, which can be issued in the form of cash or additional shares.

Liquidation Preference: The order in which different classes of securities are paid out during the liquidation of a company, with preferred stockholders having priority over common stockholders.