Preferred Stock

Definition

Preferred stock is a type of equity security that gives the holder a higher claim on the company's assets and earnings compared to common stock. It typically offers a fixed dividend payment and takes priority over common stock in the event of a company's liquidation.

5 Must Know Facts For Your Next Test

1. Preferred stock is considered a hybrid security, as it combines features of both debt and equity.
2. Preferred stockholders typically receive dividends before common stockholders and have a higher claim on assets in the event of a company's liquidation.
3. Preferred stock often has a fixed dividend rate, which can provide more stable income compared to the variable dividends of common stock.
4. Preferred stock can be convertible, meaning it can be exchanged for a predetermined number of common shares, or non-convertible.
5. Preferred stock is generally less volatile than common stock and is often viewed as a more conservative investment option.

Review Questions

• Explain how preferred stock differs from common stock in terms of its characteristics and priority in a company's capital structure.
  • Preferred stock differs from common stock in several key ways. Preferred stock typically has a fixed dividend rate and takes priority over common stock in the distribution of a company's earnings and assets. Preferred stockholders have a higher claim on the company's assets in the event of liquidation, and their dividends are usually paid out before any dividends are distributed to common stockholders. This makes preferred stock a more conservative investment option compared to the variable returns and lower priority of common stock.
• Describe the advantages and disadvantages of a company issuing preferred stock as a means of raising financial capital.
  • Issuing preferred stock can provide several advantages for a company seeking to raise financial capital. Preferred stock offers a more stable source of funding compared to common stock, as it provides a fixed dividend payment. This can be attractive to investors seeking a reliable income stream. Additionally, preferred stock does not dilute the voting rights of common stockholders, as it typically does not carry voting rights. However, the fixed dividend payments on preferred stock can be a disadvantage, as they represent a contractual obligation that the company must fulfill, even in times of financial distress. This can limit the company's financial flexibility compared to raising capital through common stock or debt financing.
• Analyze the role of preferred stock in a company's capital structure and how it impacts the company's overall financial risk and cost of capital.
  • Preferred stock plays a unique role in a company's capital structure, as it combines features of both debt and equity. The inclusion of preferred stock in a company's capital structure can impact its overall financial risk and cost of capital. Preferred stock is generally considered less risky than common stock, as it provides a fixed dividend and a higher claim on assets in the event of liquidation. This can make it a more attractive investment option for risk-averse investors, potentially lowering the company's cost of capital. However, the fixed dividend payments on preferred stock represent a contractual obligation, which can increase the company's financial risk and cost of capital compared to relying solely on common stock or debt financing. The optimal mix of preferred stock, common stock, and debt in a company's capital structure depends on the specific needs and financial goals of the organization.

Related terms

Common Stock:

The standard equity ownership in a company, representing a claim on the company's assets and earnings.

Dividend: A distribution of a portion of a company's earnings, decided and paid out to shareholders, usually on a quarterly basis.

Liquidation: The process of dissolving a company and distributing its assets to creditors and shareholders.