Preferred stock is not issued by all companies. It is called "preferred" because its holders receive available dividend payments before common stockholders, and they also receive payments from liquidation of assets before common stockholders if the company must declare bankruptcy. There are several types of preferred stock:
- Cumulative preferred stock: If a corporation fails to pay the full dividend on its preferred stock, all preferred dividends are considered to be in arrears and must be paid to holders of cumulative preferred stock before common stockholders receive their dividends.
For example, if the preferred stock pays a 6% yield, but the company has only paid $2 per share for the past two years, it will owe shareholders a total of $14 in the third year:
That is, Year1 ($6 owed - $2 paid) + Year2 ($6 owed - $2 paid) + Year3 ($6).
- Convertible preferred stock: Convertible preferred stock can be exchanged for common stock at a specific price and at the discretion of the shareholder. When this occurs, the value of the common stock for which the preferred stock is exchanged is called the conversion price. If the par value of the preferred stock is $100 and the conversion price is $20, the conversion ratio is 5-to-1. That is, the preferred shareholder would receive five shares of common stock.
It is advantageous for the shareholder to convert to common stock above the conversion price. Note, though, that convertible preferred stock pays a lower dividend than other types of preferred stock because it has the convertible feature. Still, the convertible preferred shareholder has the advantage of receiving a higher dividend payment than common stock affords, while at the same time owning the ability to convert to common stock to take advantage of capital appreciation.
Make sure you can distinguish between conversion price and conversion ratio and you know how to calculate the conversion ratio! The conversion ratio equation is the same for convertible bonds and convertible stocks:
Conversion ratio = Par Value
For more information on the potential benefits of convertible preferred shares and determining the profits of converting and the conversion premium, refer to the article Introduction to Convertible Preferred Shares.
Callable preferred stock: When a company issues callable preferred stock, it has the right to repurchase the stock, or call it, at a specific price in the future. This price, called the call price, is usually higher than the stock's par value, in order to give investors an incentive to buy the stock.
- Participating preferred stock: This type of preferred stock pays the holder a higher dividend above and beyond a certain level of its common dividend when a company has extremely good earnings in a given year. For example, a stock might normally pay a 4% preferred dividend, but it is participating up to 7%. In this instance, the shareholder would receive 4% until the common stock dividend reached a predetermined level, at which time the participating preferred stock would receive an additional dividend amount by participating in the common stock dividend until the dividend reached 7% of the par value.of the preferred.
Exam Tips and Tricks
You will be tested on the different types of preferred stock. Tag the descriptive name of each one to the concept behind the stock issue.
Order of Payment Upon Bankruptcy
Now that we've discussed all of the securities issued by a corporation, let's review using a commonly cited topic: order of payment upon bankruptcy. When a company declares bankruptcy and its assets are liquidated, the order in which various entities receive their monies is as follows:
- Wages owed to employees
- IRS (taxes)
- Secured debt
- Unsecured debt and general creditors
- Subordinated debt
- Preferred stockholders
- Common stockholders
Exam Tips and Tricks
On the Series 6 exam you may be asked to identify which investment holder is paid first or last in the event of a company's bankruptcy.
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