Saturday, October 24, 2009

Disadvantages of preferred stock

The two major disadvantages of preferred stock are the seniority of the holder's claims and its cost.
Seniority of the holders´ claims.
Since holders of preferred stock are given preference over common stock holders with respect to the distribution of earnings and assets, the presence of preferred stock in a sense jeopardizes common shareholder's returns. Adding preferred stock to the firm's capital structure creates additional claims prior to those of common stockholders. If the firm's after-tax earnings are quite variable, its ability to pay at least token dividends to common stockholder may be seriously impaired.
The cost of preferred stock financing is generally higher than the cost of debt financing. This is because the payment of dividends to preferred stockholders is not guaranteed, whereas interest on bond is. Since preferred shareholders are willing to accept the added risk of purchasing preferred stock rather than long-term debt, they must be compensated with a higher return. Another factor causing the cost of preferred stock to be significantly greater than that of long-term debt is the fact that interest on long-term debt is tax-deductible, while preferred dividends must be paid from earnings after taxes.

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