Preferred stock

The other major form of stock issued today is preferred stock. Each share of preferred carries a stated annual dividend expressed as a percent of the stock's par value. For example, if preferred shares carry a $100 par value with an 8 percent dividend rate, then each preferred shareholder is entitled to dividends of $8 per year on each share owned, provided the company declares a dividend. Common stockholders would receive whatever dividends remain after the preferred shareholders receive their stated annual dividend.
Preferred stock occupies the middle group between debt and equity securities, including advantages and disadvantages of both forms of raising long-term funds. Preferred stockholders have a prior claim over the firm's assets and earnings relative to the claim of common stockholders. However, bondholders and other creditors of the firm must be paid before either preferred or common stockholders receive anything. Unlike creditors of the firm, preferred stockholders cannot press for bankruptcy proceedings against a company which fails to pay them dividends. Nevertheless, preferred stock is part of a firm's equity capital and strengthens a firm's net worth account allowing is to issue more debt in the future. It also is a more flexible financing arrangement than debt since dividends may be passed if earnings are inadequate or uncertain and there is no fixed maturity date.
Generally, preferred stockholders have no voice or vote in the selection of management unless the corporation "passes" dividends (i.e., fails to pay dividends at the agreed-upon time). A frequent provision in corporate charters gives preferred stockholders the right to elect some members of the board of directors if dividends are passed for a full year. Dividends on proffered stock, like those paid on common stock are not a tax-deductible expense. This makes preferred shares nearly twice as expensive to issue as debt for companies in the top-earning bracket. However, IRS regulations specify that 85 percent of the dividends on preferred stock received by a corporate investor are not taxable. This tax-exemption feature makes preferred stock especially attractive to companies seeking to acquire ownership shares in other firms and sometimes allows preferred stock to be issued at a lower net interest cost than debt securities. In fact, corporations themselves are the principal buyers of preferred stock issues.
Most preferred stock is cumulative, which means that the passing of dividends results in an arrearage which must be paid in full before the common stockholders receive anything. A few preferred shares are participating, allowing the holder to share in the residual earnings normally accruing entirely to the common stockholders. To illustrate how the participating feature might work, assume that an investor holds 8-percents participating preferred stock with a $100 par value. After the issuing company's board of director's votes to pay preferred shareholders their stated annual dividend of $8 per share, the board also declares a $20-a-share common stock dividend. If the formula for dividend participation calls for common and preferred shareholders to share equally in any net earnings, then each preferred shares will earn an additional $12 to bring its total dividend to $20 per share as well. Not all participating formulas are this generous, however, and most preferred issues are nonparticipating since the participation feature is detrimental to the interests of the common stockholders.
Most corporations plan to retire their preferred stock, even though it carries no stated maturity. In fact, the bulk of preferred shares issued today have call provisions. When interest rates decline, the issuing company may exercise the call privilege at the price (which usually includes a premium over par) stated in the formal agreement between the firm and its shareholders. A few preferred issues are convertible into shares of common stock at the investor's option. The company retires all converted proffered shares and may force conversion by simply exercising the stock's call privilege. New preferred issues today are often accompanied by a sinking fund provision whereby funds are gradually accumulated and set aside for eventual retirement of preferred shares. A trustee is appointed (usually a bank trust department) who collects sinking fund payments from the company and periodically calls in preferred shares or occasionally purchases them in the open market. While sinking fund provisions allow the issuing firm to sell preferred stock with lower dividend rates, payments into the fund drain earnings and reduce dividend payments flowing to common stockholders.
From the standpoint of the investor, preferred stock represents an intermediate investment between bonds and common stock. Preferred shares often provide more income than bonds but also carry greater risk. Preferred shares prices fluctuate more widely than bond prices for the same change in interest rates. Compared to common stock, preferred shares generally provide less total income (considering both capital gains and dividend income) but are, in turn, less risky. They appeal to the investor who is looking for a favorable, but moderate rate of return.
Among major corporations preferred stock experienced a resurgence of interest during the 1970s due to high debt financing cost, the greater flexibility of preferred stock financing over bonds, and pressure on many firms (especially public utilities) to rebuild their equity positions. The numbers of issues of preferred stock listed on the New York stock exchange reached a low of 373 in 1965 and then rose to record highs during the 1970s. Many of these new preferred stock issues proved to be extremely popular with investors because of their high dividend yields, which, in several recent periods, have averaged about twice as large as the dividends yield on listed common stock.