Learn the key advantages and disadvantages of preferred stocks in corporate finance. Understand how preferred shares work, their features, and their role in long-term financing. Perfect for BITM, BBA, and BBS students.
Thank you for reading this post, don't forget to subscribe!Understanding the Concept of Preferred Stocks
In corporate finance, preferred stocks (or preferred shares) represent a hybrid form of financing that combines features of both equity and debt. For students studying Fundamentals of Corporate Finance under courses like BITM, BBA, and BBS, understanding preferred stocks is essential, as they play a crucial role in a company’s capital structure and long-term financing decisions.
This article provides a detailed explanation of preferred stocks, their features, advantages, and disadvantages, helping you grasp their importance from both corporate and investor perspectives.
What is Preferred Stock?
Preferred stock, also known as preferred share is a type of ownership in a company that provides shareholders with a fixed dividend before any dividends are paid to common shareholders.
- Unlike common stockholders, preferred shareholders usually don’t have voting rights, but they enjoy greater stability in dividend income and priority in case of liquidation.
Preferred shares are often considered a hybrid security because they carry features of both debt (fixed returns) and equity (ownership stake).
Key Features of Preferred Stocks
Here are some of the key features of preferred stocks:
- Par Value
- Fixed Dividend
- Maturity
- Cumulative Feature
- Voting Rights
- Call Feature
- Conversion Features
1. Par Value
Preferred stocks are issued with a par value, which represents their face value. This value is important because the dividend on preferred shares is usually calculated as a percentage of the par value.
- For example, if a preferred share has a par value of $100 and offers an 8% dividend rate, the shareholder will receive $8 annually. Par value also provides a basis for redemption if the company buys back the shares.
2. Fixed Dividend
One of the main features of preferred stock is that it pays a fixed dividend. This means shareholders receive a predetermined amount regularly, regardless of the company’s profit levels. The fixed dividend makes preferred stock similar to debt securities, offering investors stable income.
3. Maturity
Most preferred stocks are perpetual, meaning they do not have a specific maturity date and can exist indefinitely. However, some types may have a defined maturity period, after which the issuing company must redeem or buy back the shares.
4. Cumulative Feature
Preferred stocks may include a cumulative feature, which protects investors by ensuring they receive any missed dividend payments. If a company is unable to pay the dividend in a particular year, the unpaid amount accumulates as “dividends in arrears.” These accumulated dividends must be fully paid to cumulative preferred shareholders before any dividend is given to common shareholders.
5. Voting Rights
Generally, preferred shareholders do not have voting rights in the company, unlike common shareholders. However, in certain situations—such as when a company fails to pay dividends for several consecutive periods—preferred shareholders may be granted temporary voting rights.
6. Call Feature
A call feature allows the issuing company to repurchase or redeem preferred shares at a predetermined price after a specific date. Companies often exercise this option when interest rates decline or when they want to reduce their dividend obligations. When shares are called, investors typically receive a call premium, which is slightly above the par value, as compensation.
7. Conversion Features
Some preferred stocks come with a conversion feature that allows shareholders to convert their preferred shares into a fixed number of common shares. This feature is attractive to investors who want the stability of preferred dividends but also the potential for capital gain from rising common stock prices.
8. Sinking Fund
A sinking fund provision requires the company to set aside funds periodically to repurchase or retire preferred shares. This feature reduces the risk for investors because it ensures the company is gradually lowering its outstanding obligations. Sinking funds help maintain investor confidence and may increase the likelihood of receiving the redemption value at maturity or call date.
Advantages of Preferred Stocks
Preferred stocks offer several benefits to both the issuing company and the investors. Below are the key advantages:
- Stable Source of Long-Term Finance
- No Voting Rights
- Fixed Dividends
- Priority Over Common Stockholders
- Flexible Financing Option
- Tax Advantage for Companies (in Some Cases)
Disadvantages of Preferred Stocks
Despite their benefits, preferred stocks also come with limitations that companies and investors must consider.
- Costlier Than Debt
- Fixed Dividend Obligation
- Limited Voting Rights
- Possible Call Risk
- Dilution of Earnings
Comparison: Preferred Stocks vs Common Stocks
| Basis | Preferred Stocks | Common Stocks |
|---|---|---|
| Dividend Payment | Fixed and prior | Variable and residual |
| Voting Rights | Usually none | Full voting rights |
| Risk Level | Lower | Higher |
| Claim on Assets | Priority | Secondary |
| Convertibility | Sometimes convertible | Not applicable |
Role of Preferred Stocks in Corporate Finance
Preferred stocks are often used as part of the optimal capital structure — balancing risk, cost, and control. Companies issue preferred shares to:
- Strengthen long-term financing capacity
- Avoid increasing debt burden
- Maintain management control
- Attract institutional investors looking for steady income
Thus, they serve as a strategic financing tool that bridges the gap between debt and equity financing.
Conclusion
Preferred stocks provide a balanced blend of security and income for investors and flexible financing for companies. While they may be more costly than debt, their ability to raise long-term funds without diluting control makes them a valuable instrument in corporate finance.
Understanding their advantages and disadvantages helps finance students and professionals make informed decisions regarding investment and capital structure strategies.
Explore more: Check out our detailed guide on Sources of Long-Term Financing and Long-Term Debt Instruments to deepen your understanding of corporate funding strategies.
FAQs on Preferred Stocks
1. What are preferred stocks in simple terms?
Preferred stocks are hybrid securities that pay fixed dividends and have priority over common stock in dividends and liquidation but usually don’t carry voting rights.
2. Why do companies issue preferred stock?
Companies issue preferred shares to raise long-term capital without giving up control or taking on debt obligations.
3. What are cumulative preferred shares?
Cumulative preferred shares ensure that any missed dividends are accumulated and paid before dividends to common shareholders.
4. Is preferred stock a debt or equity?
Preferred stock is a hybrid of both — it represents ownership (like equity) but offers fixed income and priority claims (like debt).
5. What is the main disadvantage of preferred stock for investors?
The main disadvantage is limited or no voting rights and the potential for callable redemption by the issuing company.