Understand the concept of preferred stock and its essential features with clear explanations for students of Fundamentals of Corporate Finance in BITM, BBA, and BBS courses in Nepal. Learn how preferred shares differ from common stock and their role in corporate financing.
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In the world of corporate finance, companies often raise funds through two major sources — debt and equity. While common stock is the most familiar form of equity, another important instrument known as preferred stock (or preference shares) plays a unique role in corporate financing.
Preferred stock is a type of ownership in a corporation that combines characteristics of both equity and debt. It represents a hybrid security — providing shareholders with fixed dividends like bonds, yet maintaining ownership rights similar to equity investors.
For students studying Fundamentals of Corporate Finance under BITM, BBA, or BBS courses in Nepal, understanding preferred stock is crucial, as it bridges the gap between pure equity and fixed-income securities.
Concept of Preferred Stock
Preferred stock, also known as preference shares, refers to shares that have a priority claim over common stockholders when it comes to dividend payments and asset distribution during liquidation.
- It is one of the major source of long term capital.
- It occupies an intermediate position between long term debt and common equity.
While preferred shareholders typically do not enjoy voting rights, they receive a fixed dividend before any dividends are distributed to common shareholders.
- Because of this, preferred stock is often viewed as a safer investment compared to common stock, though it offers limited growth potential.
In essence, preferred stock is a hybrid financial instrument with combined features of both debt and common stock.
Features of Preferred Stock
Preferred stock exhibits several defining features that distinguish it from other forms of equity and debt instruments. Let’s explore its major characteristics:
- Par Value
- Maturity
- Fixed Dividend
- Priority in Dividend Payments
- Claim on Asset and Income
- Limited or No Voting Rights
- Convertibility Option
- Call Feature
- Cumulative and Non-Cumulative Dividends
1. Par Value
Preferred stock has a nominal or face value, stated in the corporate charter. Dividends are usually calculated as a percentage of the par value, not the market price.
2. Maturity
Preferred stocks are generally considered perpetual and do not have a fixed maturity. However, some preferred shares can be redeemable after a certain period, depending on the terms.
3. Fixed Dividend
Preferred shareholders are entitled to receive dividends at a predetermined fixed rate, regardless of the company’s profitability. This fixed-income feature makes preferred stock attractive to risk-averse investors who seek steady returns.
4. Priority in Dividend Payments
Preferred shareholders have first claim on dividends before any payment is made to common shareholders. This ensures a more stable and predictable income stream.
5. Claim on Asset and Income
In case of liquidation, preferred shareholders have a higher claim on assets and income than common shareholders, but they are still subordinate to creditors and bondholders.
6. Limited or No Voting Rights
Unlike common shareholders, preferred shareholders usually do not have voting rights in the company’s management or policy decisions. This makes preferred stock more suitable for investors seeking financial returns rather than control.
7. Convertibility Option
Some preferred shares are convertible, allowing shareholders to convert them into a specified number of common shares after a certain period or under specific conditions. This feature provides the potential for capital appreciation.
8. Call Feature
Many preferred stocks are callable, meaning the issuing company can redeem them at a predetermined price after a specific date. This provides flexibility to the company to restructure its capital if interest rates change.
9. Cumulative and Non-Cumulative Dividends
Preferred stock can be either:
- Cumulative, where unpaid dividends accumulate and must be paid before common shareholders receive any dividends.
- Non-Cumulative, where unpaid dividends are forfeited and not carried forward.
Cumulative preferred shares are more favorable for investors as they ensure dividend security.
Types of Preferred Stock
Preferred stock can take several forms depending on the rights and features attached:
- Cumulative Preferred Stock – Dividends accumulate until paid.
- Non-Cumulative Preferred Stock – Missed dividends are not carried forward.
- Participating Preferred Stock – Allows shareholders to earn extra dividends based on profits.
- Convertible Preferred Stock – Can be converted into common shares.
- Callable Preferred Stock – Can be repurchased by the company at a specified time and price.
Importance of Preferred Stock
Preferred stock serves a strategic role in corporate financing for both issuers and investors:
- For Companies: It provides capital without increasing debt or diluting control, since preferred shareholders usually lack voting rights.
- For Investors: It offers a reliable income source and higher security compared to common stock, making it ideal for conservative investors.
Thus, preferred stock helps balance a company’s capital structure, providing flexibility and financial stability.
Preferred Stock vs. Common Stock
| Basis of Comparison | Preferred Stock | Common Stock |
|---|---|---|
| Dividend Payment | Fixed dividend | Variable dividend |
| Priority | Higher priority in dividend and liquidation | Lower priority |
| Voting Rights | Usually none | Full voting rights |
| Convertibility | Often convertible | Non-convertible |
| Risk Level | Moderate | High |
| Growth Potential | Limited | High |
Conclusion
The concept of preferred stock lies at the intersection of equity and debt financing, offering a balance of safety and return. With its fixed dividend, priority rights, and flexible features like convertibility and callability, preferred stock provides both investors and companies a valuable financial instrument.
For students of BITM, BBA, and BBS courses in Nepal, mastering this topic is essential to understanding how corporations design their capital structures and manage investor relations.
Call to Action:
Explore other related topics like common stock valuation, bond valuation, and capital budgeting techniques in our Fundamentals of Corporate Finance section to strengthen your financial knowledge base.
FAQs on Preferred Stock
Q1. What is preferred stock in simple terms?
Preferred stock is a type of share that offers fixed dividends and has priority over common stockholders in dividend payment and liquidation.
Q2. How is preferred stock different from common stock?
Preferred stockholders receive fixed dividends and have priority in payments, while common stockholders enjoy voting rights and variable dividends.
Q3. What is a cumulative preferred share?
Cumulative preferred shares ensure that if dividends are skipped in one year, they accumulate and must be paid in future years before common shareholders receive any dividends.
Q4. Why do companies issue preferred stock?
Companies issue preferred stock to raise capital without taking on additional debt and without giving up control through voting rights.
Q5. Are preferred stocks risk-free?
No, preferred stocks are not risk-free, but they are less risky than common stocks due to fixed dividends and payment priority.