PREFERRED STOCK



Preferred stock is a form of corporate hybrid financing having characteristics of both debt and common stock. The financial markets view it as a form of debt, but accountants typically place it on the balance sheet as an equity account. Preferred stock units are called shares, with a par value per share and usually no maturity. When preferred stock has a maturity, usually 20 years, it also has a call feature. The shares may have a dividend (fixed) rate or dividend per share specified on a per annum basis but paid prorated quarterly. As preferred stock with a constant dividend per share with no maturity is a perpetuity, the valuation of it is based on the following formula:

where P = the price per share,
D = the annual dividend,
i = the interest rate in decimal form.

When the dividend rate is different from current market rates, the preferred stock price per share deviates from its par value. The dividend can change relative to current market interest rates. If so, the preferred stock is called adjustable rate (or variable rate) preferred stock. The mechanism detailing the calculation and frequency of adjustment of the dividend rate would be stated in the indenture (contract). As adjustable rate preferred stock continuously provides a return comparable to prevailing market conditions, the valuation of it is approximately par value. An advantage to the corporation issuing preferred stock is that the dividend is not an obligation as are debt interest payments. If preferred stock dividends are not paid, the consequence to the firm is not insolvency and bankruptcy. When the firm's preferred stock dividend is not paid, it accumulates (cumulative clause) as dividends in arrears. No common stock dividend can be paid until the arrearage has been made up. Most preferred stocks issues provide for voting rights enabling the preferred stockholders as a class to elect at least one director on the board if the preferred stock dividend has been foregone for six consecutive quarters or more. Otherwise, preferred stock has no voting rights. Approximately one-half of the preferred stock in the United States has a convertible put option. This gives convertible preferred stockholders the right to exchange their preferred stock to the company in return for its common stock within a conversion period of several years. When the preferred stock is convertible, a call feature is usually included giving the firm the right to buy back the convertible preferred stock for cash.

The tax implications of owning and selling preferred stock have largely determined the lack of interest in preferred stock in the United States. For the issuing corporation the preferred stock dividend payments are not tax deductible. Thus, the after-tax cost is the same as the before-tax cost. This tax-code ruling makes preferred stock an expensive form of financing, especially when it is viewed as a form of debt that allows interest expense to be used as a tax deduction.

In the United States, the negative tax ruling on preferred stock dividends is mitigated by a 70 percent dividend income exclusion on the tax returns of corporations. That is, if a corporation owns preferred stock, it can exclude 70 percent of dividend income and pay income taxes on only 30 percent of dividend income, both preferred and common stock. This feature of the tax code has caused a clientele effect whereby the vast majority of preferred stock is owned by corporations as opposed to individuals. On average, preferred stock is only about 4 percent of the total source of funds for U.S. firms and is concentrated in the banking and public utility industries. Nevertheless, the popularity of any instrument can fluctuate with changing market conditions, tax code, and specific features included in the preferred stock indenture.

[ Raymond A. K. Cox ]

FURTHER READING:

Chandy, P. R., L. Paul Hsueh, and Y. Angela Liu. "Effects of Preferred Stock Re-rating on Common Stock Prices: Further Evidence." Financial Review 28, no. 4 (November 1993): 449-67.

Houston, Arthur L., Jr., and Carol Olson Houston. "Financing with Preferred Stock." Financial Management 19, no. 3 (autumn 1990): 42-54.

Wansley, James W., Fayez A. Elayan, and Brian A. Maris. "Preferred Stock Returns, CreditWatch, and Preferred Stock Rating Changes." Financial Review 25, no. 2 (May 1990): 265-85.



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