Preferred stock

Definition

Preferred stock is a type of equity security that typically provides its holders with a fixed dividend before any dividends are paid to common shareholders. This form of stock combines features of both equity and debt, often appealing to investors seeking steady income and priority in asset liquidation, thus making it significant in various financial contexts.

5 Must Know Facts For Your Next Test

1. Preferred stockholders generally have no voting rights but receive dividends that are often higher than those paid on common stock.
2. In the event of liquidation, preferred stockholders have a higher claim on assets than common stockholders, but are subordinate to debt holders.
3. Dividends on preferred stock can be cumulative, meaning that if they are not paid in one period, they must be paid in future periods before any dividends are paid to common shareholders.
4. Some preferred stocks are convertible into common shares at the discretion of the holder, providing potential for capital appreciation.
5. Preferred stocks can be callable, allowing the issuing company to repurchase them at a specified price after a certain date, providing flexibility for the company.

Review Questions

• How does preferred stock differ from common stock in terms of dividends and voting rights?
  • Preferred stock differs from common stock primarily in the nature of dividends and voting rights. Preferred shareholders receive fixed dividends that are typically prioritized over any dividends paid to common shareholders. However, preferred stockholders usually do not have voting rights in the company’s governance, which contrasts with common shareholders who typically have the right to vote on corporate matters. This structure makes preferred stock attractive to investors seeking income stability while giving up some control over corporate decisions.
• Discuss the implications of cumulative dividends on preferred stock for investors and companies during financial downturns.
  • Cumulative dividends on preferred stock create an obligation for companies to pay missed dividends in future periods before they can distribute any dividends to common shareholders. For investors, this feature provides an added layer of security during financial downturns since they can expect to receive owed dividends once the company returns to profitability. For companies, while this can be beneficial for attracting investment by reassuring investors, it can also strain cash flow during tough economic times if significant dividend arrears accumulate.
• Evaluate the role of preferred stock as a hybrid security in a company's capital structure and its effects on financing strategies.
  • Preferred stock serves as a hybrid security by combining characteristics of both equity and debt, which allows companies to utilize it strategically within their capital structure. By issuing preferred stock, firms can raise capital without diluting voting control like common equity would. Additionally, since preferred dividends are typically fixed and may be cumulative, they provide a predictable cost of financing. This blend of features enables companies to optimize their financing strategies by balancing risk and return while catering to investor preferences for income stability.

Related terms

common stock: Common stock represents ownership in a company and typically gives shareholders voting rights, but dividends are not guaranteed and may fluctuate.

dividend: A dividend is a portion of a company's earnings distributed to shareholders, usually in the form of cash or additional shares.

convertible securities: Convertible securities are financial instruments, like bonds or preferred stock, that can be converted into a predetermined number of the company's common shares.