Preferred stock

C- Preferred Stock

Preferred stock is naturally called such because it gives preferential rights to dividends and residual assets in case of liquidation. The guaranteed dividend makes preferred stock more similar to a fixed income security such as bonds, than to common stock. Yet, it is a fractional share of ownership, just as common stock, and preferred shareholders cannot put the corporation in default. Thus, they are somewhere between equity and debt. Companies use preferred stock precisely when there needs fall somewhere the two as well. For instance, a company needs new capital to undertake a new research which may produce a new product line in one or several years, or fail altogether. Financing this project with debt is out of the question since no assured cash flow is anticipated. Financing with common stock would be acceptable, but the common stock would have to be retired if the new product line does not materialize, and common stock may be more difficult to sell. Preferred stock is easier to sell because of the guarantees it offers, and it is safer for the corporation than a bond issue because preferred shareholder cannot put the company in default; if the project it funded is unsuccessful, the corporation can retire the preferred stock whenever it is convenient.

Preferred stock is often looked upon as temporary equity. For instance, Dow Chemical shows its $117,000,000 of preferred stock as a temporary equity in 1999 Annual Report. Most of the preferred stock in the United States is due to be converted or retired. The conversion right or the attached warrant, make the preferred stock a hybrid security, as well as temporary. As mentioned earlier, these features make this stock more attractive to investors: an assured fixed payment and a potential for appreciation. The difference between warrant and conversion right was covered in the previous section, and it sums up to the fact that the warrant offers a potential of an additional source of equity funding for the corporation, whereas the conversion right terminates the temporary feature of preferred stock to make it permanent.

Because making this stock especially attractive to investors is important, several sweeteners are often added to preferred stock. Most usual is the cumulative feature of dividends assuring preferred shareholders that if their fixed dividend is missed in any year, the company will pay it later. Occasionally, the fixed dividend can be incremented by a participation in profits along common shareholders; it is then called participating preferred stock. Finally, preferred shareholders can be given voting rights, so that they have some say in the direction of the company.

To assure that a preferred stock is indeed a temporary capital, there are several provisions that the company will use to retire preferred stock. Sometimes, a preferred stock will have a maturity, at which time it would be retired at its redemption value (which is normally also its par value). To assure that the firm has the necessary money to retire the preferred stock, a sinking fund provision mandates an accumulation of funds for that purpose. A call provision is also common because the company may want to have even more leverage and flexibility to decide the proper time for retiring the preferred stock, or to force the preferred shareholder to use conversion rights.

With all its advantageous features, it is no surprise that the preferred stock is usually more attractive to investors than common shares of the same company. Flotation cost can also be reduced considerably compared to common stock because institutional investors are often eager to take large portions of such issues.

-- Difference in risk of company. --

See review questions Q-12C.1 through Q-12C.7.

See research assignments R-12C.1 and R-12C.2.

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Last modified: Jun/01/01 Next: Bonds