What is Preferred Stock?
Preferred stock allows an investor owns a stake at the issuing company with a condition that whenever a company decides to pay dividends, the holders of this stock will be first to be paid. They usually have the right to receive the dividend before common stockholders, which means that the preferred stockholders will be paid dividends on first priority and then onwards any dividends remaining will go over to common stockholders. This stock is also commonly known as preference share.
Preferred stock is also stated as a quasi debt tool as they are the combination of the characteristics of debt and equity both. On one hand, to receive a dividend at a fixed rate, they carry preferential right over the ordinary shares whereas on the hand they take on the unsecured equity risk, except to preferential right on behalf of repayment in the occurrence of winding up of the company or organization.
Types of preferred stock
Other than common stock, there are a variety of features or characteristics that can be added to preferred stock in a position to either enhance its position and attractiveness to investors or to make it easier and simpler for the issuing company to buy back of stock or shares. In order to achieve the goal of the company and to meet the needs of investors we may elect to use just one of the following features or characteristics, or several at once provided below:
#1 – Cumulative preferred stock
Cumulative stock or shares where undeclared dividends permitted to accumulate still they are paid which means it has a right to a particular amount of dividends every year. If the dividend are not able paid or declared, the stock can accumulate the dividends unpaid for a future period in which they are declared
source: Hanesbrands Inc
#2 – Non-cumulative preferred stock
Whereas in the case of non-cumulative stock, if the dividend is not available to declare in the current period than the preferred stock face the situation to lose any kind of dividend. The non-cumulative stock does not accumulate any kind of unpaid dividend. It does not utilize the dividend in arrears account for unpaid dividends.
#3 – Redeemable preferred stock
The redeemable stock can be redeemed on or after a period fixed for redemption under the terms and conditions of issue or after giving proper notice for the redemption to preference stockholders. The companies act, however, imposes certain restrictions for the redemption of such stock.
#4 – Irredeemable preferred stock
Irredeemable stock is those types of stock or shares that cannot be redeemed during the lifetime or period of the company.
#5 – Convertible Preferred stock
In the case of convertible stock, the convertible character provides a company to transfigure their stock into pre-decided numbers of shares of common stock of the organization or company at some point in the future. The conversion features or characteristics are at first set a transmutation rate that is not fascinating in the eyes of investors at the time of purchase or buys. However, if the cost of the ordinary stock hike, then the investors can transform into ordinary stock, and may then the stock will dispose to realize an instant profit.
We can see the details of convertible preferred stock through the following illustration if an ABC LTD. paid $ 500 for a share that converts to five stock of the common stock of the company. The common stock initials sell for $ 100 per stock, so ABC Ltd. I would earn no gain from the conference. However, afterward, it has been increased to $ 175 per stock, so ABC Ltd. would be willing to convert to ordinary stock and sold his five shares of common stock for a total of $ 875, thereby receiving a profit of $ 375 per stock of preferred stock purchased. This is considered valuable characteristics if there is an expectation that the amount of the organization will enhance during a time period.
#6 – Non-convertible Preferred stock
In the case of non-convertible stock, the holders of non-convertible stock have no such right of conversion.
#7 – Participating Preferred stock
The holders of participating preferred stock have a right to participate in the surplus or additional profits of the company remained after paying the dividend to the ordinary shareholders and preference shareholders at a fixed rate.
#8 – Non-participating preferred stock
Whereas in the case of non-participating stock, the preferred stock do not have such a right to participate in surplus or additional profits.
Advantages – Company’s point of view
- The dividend payable on this stock is fixed which is usually lower as compared to payable on equity shares. As a result, they facilitate the company in enhancing the profits convenient for the dividend available to equity shareholders.
- Preferred shareholders have no voting right on matters that not effecting their right from now promoters or management can keep command over the circumstances of the corporate.
- The corporate or the organization should continue limberness in its capital structure through issuing of redeemable preferred stock or shares as they will be redeemed under the conditions of issue.
- The issue of such stock does not prove or state a burden on finance of the company because the reason behind this is, the dividends are paid only if the sufficient amount of financial surplus available or on dividends are to be paid.
- Non-availability of payment of dividend on preference stock does not generate a charge on the company’s assets.
- The issue of this stock spread the range of capital markets as they provide security not only to the investors but also to fixed return. If the company is not able to issue preferred stock which means it will insufficient to create the attraction for the capital from such ordinary types of investors.
Advantages – Investors point of view
- Investors in cumulative preferred stock get a fixed rate of dividend on this stock uniformly even if there is none availability of profit. If there are any arrears regarding dividends is available will be paid in the years of profit.
- Preferred stock carries preference right as regards the payment of dividends and preferential right as evaluate to paying back of capital in happening of the company’s winding up, as a consequence, they enjoy a lower rate of risk.
- Preference stockholders are provided voting rights in the occurrence that directly affecting their interest, which clearly stated that interest is their protection.
- As the preference stockholders take delights that the preferential rights of their capital’s repayment in case of winding up of the company, it provides them protection from capital loses.
- These stocks is stated as fair securities for the shareholders during the recession periods when the profits of the company are down.
Disadvantages – Company’s Point of view
- The company is to pay dividends at a higher rate on these stocks than the existing rate of interest on the debentures. As a result, it generally enhances the cost of the capital of the company.
- Generally, most of the preferred stock is issued cumulative which means that all the arrears of dividends must be paid on first priority before any can be paid to equity stockholders. It is the responsibility of the company to pay the dividend on such kinds of shares. Which results in a reduction of the profits of the equity shareholders.
- The debt freeness of the company is extremely influenced by the issue of preferred stock. The creditors may anticipate that the continuity of dividend on stock and adjournment of dividend on equity capital may divest them with regarding the chance of getting back their sum amount in full in the happening of cessation of the company, as the preferred capital has the preference right on the assets of the company.
- The amount of preference dividend does not affect any reduction in taxable income.
Disadvantages – Investors Point of view
- There is no availability of any voting rights to preference stockholders except in matters directed to affect their interest.
- The dividend on such stocks other than the participating preferred stock is fixed even if the company is earning higher profits.
- The preference shareholders have no claim over the surplus amount or figure. They can only ask for the return of their capital amount invested in the company.
- The company does not provide any safeguard to the preference capital as is made in case of debentures. Which results in non-protection of their interest by the assets of the company.
Cost of Preferred stock
The cost of preferred stock capital is the rate of return that must be earned on preference capital financed investments, to keep unchanged the earnings available to the equity shareholders. In other words, it is the rate of return required by the holders of a company’s preferred stock.
Cost of Irredeemable preferred stock
The cost of irredeemable preferred share capital is the rate of preference dividend, also called the coupon rate divided by net issue proceeds. In the case of Irredeemable preferred stock, the cost is calculated as :
Cost of Preferred Stock Formula
Kp i.e. cost of preferred stock = Annual dividend of Preferred stock/Net proceeds received from the issue of preferred stock after meeting the issue expenses or Market price.
XYZ Limited has issued 10,000 irredeemable preference shares with a face value of $ 100 each. The cost of preference share capital is 10 %. The market price of the share is currently $ 115. Calculate the cost of preferred share capital.
Annual dividend = $ (100 * 10/100) = $ 10
Kp = $ 10/$ 115 = 8.7 %
Cost of Preferred Stock or Kp = 14 % of $ 150/ ($ 150 – $ 15) = $ 21/$ 135 = 0.1555 = 15.55 %
Cost of redeemable preferred stock
The cost of redeemable preferred stock or redeemable preference capital having fixed maturity date is calculated as follows :
Cost of Preferred Stock Formula
Kp i.e. cost of redeemable preferred stock or shares = [Annual dividend + (Redeemable value – sale value)/number of years of redemption]/ [(Redeemable value of the preferred stock or shares + sale value of shares)/2]
D limited has $ 100 preference share redeemable at a premium of 10 % with 15 years maturity. The coupon rate is 12 %. The flotation cost is 5 %. The sale price is $ 95. Calculate the cost of preferred stock or preference shares.
Redeemable value = $100+ $ 10 = $ 110
Sale value = $ 95 – $ 5 = $ 90
Annual dividend = $ 100 * 12/100 = $ 12
Kp = [12+ (110 -90)/15] / [(110 + 90)/2) = 12 + (20/15) / 200/2 = (12 + 1.33)/100 = 0.133
= 13 % (Appx)
Cost of Preferred Stock Video
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