Remember, common stock is just one form of ownership. Another popular type of ownership is preferred stock, which is very similar to bonds in that it provides steady income.

Benefits of Preferred Stocks
Shares of preferred stock are typically non-voting, but they pay a steady dividend. They have other benefits too:

  • If a company is to be liquidated, preferred stockholders have priority over common stockholders.
  • If a company does not have enough earnings in a period to pay dividends to both the preferred and the common stockholders, those with preferred stock will be the ones paid.

A company can issue more than one class of preferred stock, with different classes taking precedence over others in terms of distribution of assets or dividends.

Look Out!

Memorize the differences between the different types of preferred shares.

Types of Preferred Stock

Preferred stock, unlike common stock, may have different features associated with it. Most of the features are designed to make the issue more attractive to investors and, therefore, benefit the owners of preferred stock.

Straight/Noncumulative

The straight preferred stock has no additional features. The holder is entitled to the stated dividend rate and nothing else. If the corporation is unable to pay the dividend, it is not owed to the investor.

Cumulative Preferred

A cumulative feature protects the investor in cases when a corporation is having financial difficulties and cannot pay the dividend. Dividends on cumulative preferred stock accumulate in arrears until the corporation is able to pay them. If the dividend on a cumulative preferred stock is missed, it is sill owed to the holder. Dividends in arrears on cumulative issues are always the first dividends to be paid. If the company wants to pay a dividend to common shareholders, it must first pay the dividends in arrears, as well as the stated preferred dividend, before common shareholders receive anything.

Participating Preferred

Holders of participating preferred stock are entitled to receive the stated preferred rate, as well as additional common dividends. The holder of participating preferred receives the dividend payable to the common stockholders over and above the stated preferred dividend.

Convertible Preferred

A convertible feature allows the preferred stockholder to convert or exchange their preferred shares for common shares at a fixed price known as the conversion price.

Example

TRW has issued a 4% convertible preferred stock, which may be converted into TRW common stock at $20 per share. How many shares may the preferred stockholder receive upon conversion?

number of shares = par/conversion price (CVP)

$100/$20 = 5

The investor may receive five common shares for every preferred share.

Callable Preferred

A call feature is the only feature that benefits the company and not the investor. A call feature allows the corporation to call in or redeem the preferred shares at its discretion or after some period of time has expired. Most callable preferred stock may not be called in during the first few years after their issuance. This feature, which does not allow the stock to be called in its early years, is known as call protection. Many callable preferred shares will be called at a premium price above par. For example a $100 par preferred stock may be called at $103. The main reasons a company would call in its preferred shares would be to eliminate the fixed dividend payment or to sell a new preferred stock with a lower dividend rate when interest rates decline. Preferred stock is more likely to be called by the corporation when interest rates decline.

Adjustable-rate preferred stock dividends vary with some benchmark, typically the T-bill rate. Because adjustable-rate preferred stock always provides returns consistent with prevailing interest rates, its share price does not tend to move much.



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