Characteristics of Preferred Stock - Financial Management

Characteristics of Preferred Stock and Common Stock

The characterstics of preferred stock and common stock are :

As a source of capital for a firm, preferred stock occupies an intermediate position between long-term debt and common stock. Like common stock, preferred stock is part of the stockholders’ equity. Like long-term debt, it is considered a fixed-income security, although preferred stockholders receive dividends instead of interest payments. Because the issuing firm often does not promise repayment at a specific date, preferred stock tends to be a more permanent form of financing than long -term debt. Dividends on preferred stock, like interest payments on long -term debt, normally remain constant over time.

The popularity of preferred stock financing has declined in recent decades. Dividends cannot be deducted from income for corporate income tax purposes, whereas interest payments are tax deductible. This means that for a company paying more than one -third of its income in taxes, the after-tax cost of preferred stock is greater than that of long -term debt,assuming that the pretax preferred stock and long-term debt rates are about the same and that the company makes no change in its capital structure. Preferred stock bears its name because it usually has preference, or priority, over common stock with regard to the company’s dividends and assets.

For example, if a company’s earnings in a given year are insufficient to pay dividends on preferred stock, the company is not permitted to pay dividends on its common stock. In the event of a liquidation following bankruptcy, the claims on the firm’s assets by preferred stockholders are subordinate to those of creditors but have priority over those of common stockholders.

Features of Preferred Stock

Like long -term debt, preferred stock has its own unique distinguishing characteristics. A number are discussed here.

Selling Price and Par Value The selling price, or issue price, is the per-share price at which preferred stock shares are sold to the public. Preferred stocks are typically issued at prices of $25, $50, or $100 per share.

The par value is the value assigned to the stock by the issuing company and is frequently the same as the initial selling price. No relationship necessarily exists between the two, however. A preferred stock sold at $25 per share may have a $25 par value, $1 par value, or no par value at all. Regardless of what a preferred stock’s actual par value is, however, in the event of liquidation, preferred stockholders are entitled to the issue price plus dividends, after the claims of creditors have been paid in full. Preferred stock is usually designated by its dividend amount rather than its dividend percentage. For example, suppose Intermountain Power Company has a series of preferred stock that pays an annual dividend of $2.20, has a $1 par value, and was initially sold to the public at $25 per share. An investor would most likely refer to the stock as “Intermountain Power’s $2.20 preferred.”

Adjustable Rate Preferred Stock This type of preferred stock became popular in the early 1980s. With these issues, dividends are reset periodically and offer returns that vary with interest rates. For example, Chase Manhattan (now JP Morgan Chase) issued 9.1 million (series N) shares of adjustable rate preferred stock on April 29, 1994. The annual dividend rate was to be set quarterly at 85 percent of the highest of (1) the 3 -month U.S. Treasury Bill Rate,(2) the U.S. Treasury 10-year Constant Maturity Rate, and (3) the U.S. Treasury 30-year Constant Maturity Rate prior to each quarterly dividend period, with upper and lower limits of 10.50 percent and 4.50 percent, respectively.

Cumulative Feature Most preferred stock is cumulative. This means that if, for some reason, a firm fails to pay its preferred dividend, it cannot pay dividends on its common stock until it has satisfied all or a prespecified amount of preferred dividends in arrears. The principal reason for this feature is that investors are generally unwilling to purchase preferred stock that is not cumulative.

Participation Stock is said to be participating if the holders share in any increased earnings the company might experience.Virtually all preferred stock, however, is nonparticipating; that is, the preferred dividend remains constant, even if the company’s earnings increase.Any dividend increases resulting from higher earnings accrue directly to the common stockholders.

Maturity Preferred stock is technically part of a firm’s equity capital. As such, some firms issue preferred stock that is intended to be perpetual, that is, a permanent portion of the stockholders’ equity having no specific maturity date.Many preferred stock investors, however, desire sinking fund provisions, which guarantee that the issue will be retired over a specified time period.

Call Feature Like long-term debt, preferred stock can sometimes be redeemed, or called, at the issuing firm’s option at some specified price. For example, Citigroup’s 1997 (series R) adjustable rate preferred stock issue was callable (deferred call) on or after May 31, 1999, at a redemption price of $250 per share plus dividends accrued and unpaid to the redemption date.

Whereas the call feature allows the issuing company a measure of flexibility in its financing plans, the call feature is generally not attractive to investors. Thus, a firm usually must also provide investors with a call premium, or the difference between the call price and the original selling price, should it decide to attach a call feature to its preferred stock. The probability that a firm will exercise the call privilege is likely to increase during times when market interest rates have decreased below those that existed at the time of issue. After calling the original issue, the firm can replace it with a lower-cost issue.

Voting Rights As a general rule, preferred stockholders are not entitled to vote for the company’s board of directors. However, special voting procedures frequently take effect if the company omits its preferred dividends or incurs losses for a period of time. In such a case, the preferred stockholders often vote as a separate group to elect one or more members of the company’s board of directors. This ensures that the preferred holders will have direct representation on the board.

Trading of Preferred Shares

Following the initial sale of preferred stock by a firm, investors who purchase the shares may decide to sell them in the secondary markets. Large issues of actively traded preferred stock are listed on the major stock exchanges, such as the New York and the American stock exchanges. However, a majority of preferred stock issues are traded rather thinly, and these are traded over -the -counter.

Users of Preferred Stock

Utility companies have been the most frequent users of preferred stock financing, largely because of the regulatory treatment of preferred stock dividend payments.Utilities are permitted by their regulatory agencies to consider preferred dividends as an expense for ratemaking purposes, thus reducing the after-tax cost disadvantage of preferred stock that deters nonutility firms from making extensive use of this form of financing.

With deregulation, utility company use of preferred stock financing has been greatly reduced. Preferred stock (usually convertible) has also been used extensively in mergers and acquisitions. Frequently, acquiring companies issue preferred stock in exchange for the common stock of acquired companies. For example, Chrysler issued (convertible) preferred stock when it acquired American Motors. This, in effect, is another example of financial leverage, and it can cause an increase in the earnings per common share of the acquiring company.

Other occasional users of preferred stock financing are capital-intensive companies undertaking expansion programs. These companies may choose preferred stock as a means of securing long-term financing for the following reasons:

  • Their capital structures and various other restrictions prevent the judicious use of additional long-term debt.
  • Depressed common stock prices and the potential dilution of per-share earnings may cause them to decide against external common equity financing.

Often these same companies have relatively low marginal tax rates (because of losses and accelerated depreciation) that make the after-tax cost of preferred stock not appreciably different from that of long-term debt. For example, USX (formerly U.S. Steel) has issued preferred stock under these circumstances.

Large commercial banks are another group of preferred stock users. These banks, including Bank of America, Citigroup, and JP Morgan Chase, have issued variable -rate preferred stock, partly to get additional equity into their capital structures.

Advantages and Disadvantages of Preferred Stock Financing

From the issuing company’s perspective, the principal advantage of preferred stock is that preferred dividend payments are potentially flexible. Omitting a preferred dividend in difficult times usually results in less severe consequences than omitting an interest payment on long -term debt.

In addition, preferred stock financing can increase a firm’s degree of financial leverage. However, financial analysts may regard the issuance of preferred stock as equivalent to debt. In this case, the company is viewed as having used up a portion of its “debt capacity.” Or, in effect, the company has leveraged with preferred stock rather than long -term debt— at a greater after-tax cost.

From the investors’ perspective, companies who purchase the preferred stock of other companies accrue certain tax advantages resulting from the 70 percent exclusion of intercompany dividends from federal income taxes. For example, an insurance company in the 35 percent tax bracket can invest in the preferred stock of another company and pay taxes equal to only about 10.5 percent of the preferred dividend income. In contrast, the same insurance company would be required to include all the interest received in its taxable income.

The principal disadvantage of preferred stock financing is its high after -tax cost as compared with long-term debt because dividends cannot be deducted for income tax purposes. Thus the after-tax cost to the firm for preferred stock is generally greater than the after -tax cost of long -term debt, assuming that the firm’s capital structure remains constant. As a result, most companies considering long -term financing with fixed -income securities choose long-term debt over preferred stock.


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