Section 1.6: Preferred Stock

  • What preferred stock is and how it differs from common.

  • Types of preferred stock:

    • Straight (noncumulative)

    • Cumulative

    • Callable

    • Convertible

    • Adjustable-rate

    • Participating

  • Advantages and risks of owning preferred stock.

Overview

  • Preferred stock represents ownership in a corporation, but in a limited and specific way.

  • Holders have an interest in the company’s cash flow, not its management.

  • Preferred stock is equity, but it has debt-like characteristics (fixed income, priority, etc.).

  • Rate of return is fixed — unlike common stock, which fluctuates.

Key Features of Preferred Stock

  • Fixed Dividend:

    • Expressed as a dollar amount (e.g., $4 preferred pays $4 annually)

    • Or as a percentage of par value (e.g., 6% preferred = $6 annually on $100 par).

    • Always assume par = $100 unless stated otherwise.

    • Paid quarterly.

  • No Voting or Preemptive Rights:

    • Preferred shareholders generally cannot vote or maintain ownership percentage through preemptive rights.

  • Optional Issuance:

    • All corporations issue common stock, but not all issue preferred stock

Types of Preferred Stock

1. Straight (Noncumulative) Preferred

  • No special features — only fixed dividends.

  • Missed dividends are not paid later.

  • If the company skips payments, the shareholder loses that income permanently.

2. Cumulative Preferred

  • Accrues unpaid dividends if the company suspends or reduces them.

  • Accumulated unpaid dividends = dividends in arrears.

  • Must be paid before common shareholders receive any dividends.

3. Callable Preferred

  • Corporation can buy back (“call”) shares after a specified date, usually at a premium (e.g., $103 for $100 par).

  • Companies call shares to replace high fixed dividends with lower ones when interest rates fall.

  • Dividends stop after the call date.

4. Convertible Preferred

  • Shareholders can convert preferred shares into a fixed number of common shares.

  • Usually issued with a lower dividend rate since there’s growth potential.

  • Tracks the price of common stock once conversion becomes favorable.

    • Example: Convertible at $40 — once common rises above $40, preferred follows.

5. Adjustable-Rate Preferred

  • Dividends fluctuate based on a benchmark (e.g., Treasury Bill rate).

  • Keeps price stable because returns adjust with interest rates.

  • Least suitable for investors seeking fixed, stable income.

6. Participating Preferred

  • Receives fixed dividends + a share of extra profits.

  • Example: “6% preferred participating to 9%” → may earn an extra 3% when profits allow.

Preferred Stock

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Preferred Stock 〰️

Advantages of Preferred Stock

  • Dividend Preference: Paid before common shareholders.

  • Priority at Dissolution: Paid before common stockholders during liquidation (but after creditors).

  • More Stable Returns: Fixed income with lower volatility than common stock.

Risks of Preferred Stock

  • Purchasing Power Risk: Inflation erodes the fixed income’s value over time.

  • Interest Rate Sensitivity:

    • When interest rates rise, preferred prices fall (inverse relationship).

  • Dividend Risk:

    • Dividends can be reduced or suspended; not guaranteed.

  • Priority at Dissolution:

    • Still behind all creditors in liquidation.

Chapter 2

✺ Review questions ✺

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.

  • It all begins with an idea. Maybe you want to launch a business. Maybe you want to turn a hobby into something more.