Preferred stock (Preference Shares)

Preferred stock are equities (capital stock) which gives the holder the right to a fixed dividend  (usually a fixed percentage of the nominal value of the share) from the earnings of the company.

Preferred stocks are generally referred to as a hybrid instrument, meaning it bears properties of both equity and debt instrument. Preference shareholders are given a higher priority than common stockholders when it comes to liquidation and distribution of firm’s earnings. The preferential treatment is that preference shareholders are given precedence over ordinary shareholders with respect to the distribution of the firm’s earnings as well as the distribution of assets in the event of liquidation.

The downside to holding a Preferred stock is that although it is a form of equity, they are not allowed a share of excess profits as ordinary shareholders are entitled to. Preference shareholders are paid a fixed dividend regardless of the excess profit the company makes (except participating preference shares).

A second downside to owning Preferred stocks is that preference shareholders do not enjoy any of the voting rights common shareholders enjoy. This means that preference shareholders cannot influence decision making in the company.

Types of Preferred stocks

Types of Preferred stocks include:

1. Cumulative Preferred stock
2. Non-cumulative Preferred stock
3. Participating Preferred stock
4. Redeemable Preferred stock
5. Convertible Preferred stock

Thought i was going to end it there did you? Nah, cant leave you hanging now…*wink*!!… let’s explain further:

Cumulative Preferred stock: It is worthy of note that preference shareholders like ordinary shareholders are paid dividends only when the company’s management declares there is dividend to be paid. If in their opinion (management), if they think the profit is insufficient to declare dividends on, the preference shareholder likewise the ordinary shareholder forgoes the dividend for that particular year. Well this is not the case for a cumulative preference shareholder.

If the company makes insufficient profit, and the management refuses to pay dividend, the cumulative preference shareholder’s annual fixed rate dividend is accrued until the company has sufficient earnings to pay the dividends. This means that the dividends a cumulative preference shareholder is entitled to continues to pile up for the cumulative preference shareholder until they can receive full payment for the present dividend and whichever one that was in arrears.

Non-Cumulative Preferred stock: Non cumulative preferred stock unlike cumulative Preferred stocks do not have earnings carried over. If the company is not able to make dividend payments or there are insufficient earnings, the dividend is forgone. This means that the non-cumulative preference shareholder forgoes his dividend payment for that accounting period.

Participating Preferred stock:This is the only exception to preference shareholders not partaking in sharing excess profits. As earlier stated, the participatory preference shareholder receives fixed dividends and in addition participates in the surplus earnings with ordinary shareholders.

Redeemable Preferred stock: Holders of this type of preferred stock may opt to redeem their shares for cash at or before the date specified at the time of issue.

Convertible Preferred stock: This is a preferred stock with embedded options that allows the holder exchange his Preferred stock for a predetermined number of the company’s common stock shares. Once the option is embedded, it avails the preference shareholder the opportunity of converting his Preferred stock to common stock.

Advantages of financing by Preferred stocks

1)Preference shares increase the firm’s leverage allowing its ordinary shareholders obtain increased returns when earnings on total capital are greater than the cost of financing by Preferred stocks.

Breaking it down: It means that, in the case of the company making excess profit arising as a  result of increased total capital (via selling of preferred stocks), ordinary shareholders can enjoy increased returns because they are the only ones entitled to the firm’s excess profit since preference shareholders are paid a fixed dividend.

2) It is a less risky source of finance compared to loans and debt instruments. In the case of loans and debt instruments, a default in the payment of interest or coupons may have legal implications as the owners of these debt instruments may take the company to court inorder to seek a liquidation of the company’s assets to settle their claims.

With Preferred stocks on the other hand, there is no great risk of being forced out of business if dividends are not paid.

Disadvantages of financing by Preferred stocks

1) Payment of preference share dividends is not tax deductible like that of interest payments of debt. This means that at the end of the day, the cost may outweigh  the benefits in the form of higher taxes.

2) The seniority of preference shareholder’s claims over those of ordinary shareholders may impair the returns accruing to the ordinary shareholders.

Recommended Reading 

Frank Fabozzi., Financial management and analysis.