There are a number of ways companies can raise funds to finance upcoming projects, expansion and other high costs associated with operation, the most common including debt and equity issues.
Large corporations can choose which kinds of issues they offer to the public, and they base that decision on the type of relationship they want with shareholders, the cost of the issue and the need prompting the financing. When it comes to raising capital, some companies elect to issue preferred stock in addition to common stock or corporate bonds, but the reasons for this strategy vary among corporations.
Preference shares act as a hybrid between common shares and bond issues. As with any produced good or service, corporations issue preferred shares because consumers — investors in this case — want them. Investors value preference shares for their relative stability and preferred status over common shares for dividends and bankruptcy liquidation.
Corporations value them as a way to provide equity financing without diluting voting rights, for their callability and, sometimes, as a means of fending off hostile takeovers.
In most cases, preference shares comprise a small percentage of a corporation’s total equity issues. There are two reasons for this. The first is that preferred shares are confusing to many investors (and some companies), which limits their demand. The second is that stocks and bonds are normally sufficient options for financing.
Why Investors Demand Preference Shares
Most shareholders are attracted to preferred stock because it offers consistent dividend payments without the lengthy maturity dates of bonds or the market fluctuation of common stocks. These dividend payments, however, can be deferred by the company if it falls into a period of tight cash flow or other financial hardship. This feature of preferred stock offers maximum flexibility to the company without the fear of missing a debt dividend payment. With bond issues, a missed payment puts the company at risk of defaulting on an issue, and that could result in forced bankruptcy.
Some preferred shareholders have the right to convert their preferred stock into common stock at a predetermined exchange price. And in the event of bankruptcy, preferred shareholders receive company assets before common shareholders.
Why Corporations Supply Preference Shares
Although preferred stock acts similarly to bond issues, in that it pays a steady dividend and its value does not often fluctuate, it is considered an equity issue. Companies that offer equity in lieu of debt issues can accomplish a lower debt-to-equity ratio and, therefore, gain greater leverage as it relates to future financing needs from new investors.
A company’s debt-to-equity ratio is one of the most common metrics used to analyze the financial stability of a business. The lower this number is, the more attractive the business looks to investors. Additionally, bond issues can be a red flag for potential buyers because the strict schedule of repayments for debt obligations must be adhered to, no matter what a company’s financial circumstances are. Preferred stocks do not follow the same guidelines of debt repayment because they are equity issues.
Corporations also might value preference shares for their call feature. Most, but not all, preferred stock is callable. After a set date, the issuer can call the shares at par value to avoid significant interest rate risk or opportunity cost.
Owners of preference shares also do not have normal voting rights. So a company can issue preferred stock without upsetting controlling balances in the corporate structure.
Although common stock is the most flexible type of investment offered by a company, it gives shareholders more control than some business owners may feel comfortable with. Common stock provides a degree of voting rights to shareholders, allowing them an opportunity to impact crucial managerial decisions. Companies that want to limit the control they give to stockholders while still offering equity positions in their businesses may then turn to preferred stock as an alternative or supplement to common stock. Preferred stockholders do not own voting shares like common stockholders do and, therefore, have less influence on corporate policymaking decisions and board of director selections.
Finally, some preference shares act as “poison pills” in the event of a hostile takeover. This normally takes the form of a detrimental financial adjustment with the stock that can only be exercised when controlling interest changes.
What are some examples of preferred stock, and why do companies issue it?
There are several reasons why a company chooses to offer preferred stock, all of which relate to the financial advantages that it provides. Companies offering preferred stock include Bank of America, Georgia Power Company and MetLife.
Preferred stock derives its name from the fact that it carries a higher privilege by almost every measure in relation to a company’s common stock. Preferred stock owners are paid before common stock shareholders in the event of the company’s liquidation. Preferred stockholders enjoy a fixed dividend that, while not absolutely guaranteed, is nonetheless considered essentially an obligation the company must pay. Preferred stockholders must be paid their due dividends before the company can distribute dividends to common stockholders. Preferred stock is sold at a par value and paid a regular dividend that is a percentage of par. Preferred stockholders do not typically have the voting rights that common stockholders do, but they may be granted special voting rights.
Preferred stock provides a simpler means of raising substantial capital than the sale of common stock does. The par value that companies offer preferred stock for is often significantly higher than the common stock price. Because of tax advantages over retail investors, institutions are more typically buyers of preferred stock than individual investors, and the larger amount of capital available to institutions enables them to purchase large blocks of preferred stock. This allows the company to obtain a substantial amount of equity more easily from each stock sale. Companies often offer preferred stock prior to offering common stock, when the company has not yet reached a level of success that would make it sufficiently attractive to large numbers of retail investors. The sale of preferred stock then provides the company with the capital necessary for growth.
Preferred stock also offers companies some financial flexibility. Dividends owed to preferred stockholders can be deferred for a time if the company should experience some unexpected cash flow problems. The deferred dividends are essentially considered to be owed to the preferred stockholders, payable at some point in the future, but their deferral may be critical in helping a company bridge the gap over a period of financial difficulty. This is one way in which preferred stock is distinguished from bonds, since a company not making the interest payment due on a bond would ordinarily be considered to be in default and therefore risking bankruptcy.
The nature of preferred stock provides another motive for companies to issue it. With its regular fixed dividend, preferred stock resembles bonds with regular interest payments. Like bonds, preferred stock is rated by credit agencies. However, unlike bonds that are classified as a debt liability, preferred stock is considered an equity asset. Issuing preferred stock provides a company with a means of obtaining capital without increasing the company’s overall level of outstanding debt. This helps keep the company’s debt to equity (D/E) ratio, an important leverage measure for investors and analysts, at a lower, more attractive level.
Preferred stock is sometimes used by companies as a takeover defense by assigning very high liquidation value for the preferred shares that must be paid off if the company is taken over.
What are Advantages and Disadvantages of Preference Shares?
Preference shares carry a number of benefits for both companies and investors. The chief benefit for shareholders is that preference shares have a fixed dividend that must be paid before any dividends can be paid to common shareholders. While dividends are only paid if the company turns a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. Once the business is back in the black, all unpaid dividends must be remitted to preferred shareholders before any dividends can be paid to common shareholders.
In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim on company assets than common shareholders. This makes preference shares, also called preferred shares, particularly enticing to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are compensated for their investments sooner.
Other types of preference shares carry additional benefits. Convertible shares allow the shareholder to trade in preference shares for a fixed number of common shares. This can be a lucrative option if the value of common shares begins to climb. Participating shares offer the shareholder the opportunity to enjoy additional dividends above the fixed rate if the company meets certain predetermined profit targets. The variety of preference shares available and their attendant benefits means that this type of investment can be a relatively low-risk way to generate long-term income.
From the investor’s perspective, the main disadvantage of preference shares is that preferred shareholders do not have the same ownership rights in the company as common shareholders. The lack of voting rights means the company is not beholden to preferred shareholders the way it is to equity shareholders, but the guaranteed return on investmentlargely makes up for this shortcoming. However, if interest rates rise, the fixed dividend that seemed so lucrative can quickly look like less of a bargain as other fixed-income securities emerge with higher rates.
Preference shares also have a number advantages for the issuing company. The lack of shareholder voting rights that may seem like a drawback to investors is beneficial to the business because it means ownership is not diluted by selling preference shares the way it is when ordinary shares are issued. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing common shares. Issuing preference shares carries many of the benefits of both debt and equity capital and is considered to be a hybrid security.
Companies can also issue callable preference shares, which afford them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital. Shareholders, however, would consider this a disadvantage.
The chief disadvantage to companies is the higher cost of this type of equity capital relative to debt. However, financing through shareholder equity, either common or preferred, lowers a company’s debt-to-equity ratio, which is considered by both investors and lenders to be a sign of a well-managed business.
Does issuing preferred shares offer a tax advantage for corporations?
There is no direct tax advantage to the issuing of preferred shares when compared to other forms of financing such as common shares or debt. The reason for this is that preferred shares, which are a form of equity, are paid fixed dividends with after-tax . This is the same case for common shares. If dividends are paid out, it is in after-tax .
Preferred shares are considered to be like debt in that they pay a fixed rate like a bond (a debt investment). It is because interest expenses on bonds are tax deductible, while preferred shares pay with after-tax , that preferred shares are considered a more expensive means of financing. Issuing preferred shares does have its benefits over bonds in that a company can stop making payments on preferred shares where they are unable to stop making payments on bonds without going into default.
There are a few reasons why issuing preferred shares are a benefit for companies. One benefit of issuing preferred shares, is that for financing purposes they do not reflect added debt on the company’s financial books. This actually can save money for the company in the long run. When the company looks for debt financing in the future, it will receive a lower rate since it will appear the company’s debt load is lower – causing the company to in turn pay less on future debt. Preferred shares also tend to not have voting rights, so another benefit becomes that issuing preferred shares does not dilute the voting rights of the company’s common shares.
What is the Difference Between Preferred Stock and Common Stock?
There are a number of advantages and disadvantages to owning preferred stock over common stock shares.
A common stock is a partial claim to ownership or a share of the company’s business. Common stockholders exercise partial control of the corporation by voting to elect the board of directors and voting on corporate policy. However, common stockholders are lower priority when it comes to the structure of ownership and actual rights to the company’s assets.
If a company is liquidated, the payout to common stockholders comes only after other debt holders, bond holders and preferred stockholders have already taken their piece of the company’s assets. The claims of preferred stockholders are given, in accord with the term, preference over the claims of common stockholders. Common stockholders receive a portion of the assets only if and when all other claims are fully satisfied. That’s why common stockholders are often referred to as “residual” owners of a company.
Another sense in which preferred stockholders’ shares are “preferred” is that they typically have a right to receive fixed dividend payments, even when a company determines there are insufficient revenues to merit declaring a dividend payment for common shareholders.
Common shareholders have no guarantees to dividends. But, preferred stockholders generally do. So, in relation to sharing in a portion of the company’s income through the payment of dividends, preferred shareholders are in a significantly better position than common shareholders. Most preferred stocks are cumulative, which means that if the company fails to make a regularly scheduled fixed dividend payment to preferred shareholders, it must make up the payment before making any other kind of dividend payments.
There are certain situations in which common stockholders have an advantage over preferred stockholders. Firstly, preferred stockholders, unlike common stockholders, do not, as a rule, hold any type of voting rights regarding corporate policy or decisions of the board.
Preferred stocks offer an advantage of less volatility than common stocks, but that means they do not see the large gains that common stockholders can see. Events like a major innovation that send common stock price soaring may have comparatively little effect on the preferred stock value. For this reason, growth investors may not find preferred stock very appealing.
However, income investors are generally attracted to the stronger fixed-income position offered by preferred stock.
Most preferred stock is callable in that the company has the right to redeem or repurchase the shares, usually after a specified date. So, unlike common stockholders, preferred shareholders may have to surrender their investments earlier than they want to, and in a way that prevents them from realizing some of the income they expected to gain from holding the stock.
Why should a company buy back shares it feels are undervalued instead of redeeming them?
Repurchase and redemption are associated with different classes of stock. Common shares can be bought back by the issuing company through a tender offer or on the open market. Preferred shares can be redeemed by the issuing company at a predetermined call price. In some cases, common stock repurchase can minimize the cost of capital.
Common stock represents equity ownership of a publicly traded company. Common shares are issued in public offerings in exchange for assets or to employees as compensation. Equity financing allows businesses to raise or keep cash without increasing debt. Many mature businesses that are sufficiently capitalized choose to maximize shareholder value by disbursing cash on hand directly to holders of common stock through dividends. Share repurchases are a popular alternative to dividends used by many companies to return value to shareholders. Common stock can be bought back on the open market or through a tender offer. Stock repurchase programs reduce the number of shares outstanding, increasing the proportionate ownership of remaining shareholders.
Preferred stock is a financing instrument that exhibits some characteristics of common stock and some characteristics of corporate bonds. Holders of preferred stock collect fixed annual dividends, the value of which is determined prior to issuance. Preferred shares do not provide voting rights like common shares but are repaid in full before common shareholders are compensated in the event of liquidation. Redeemable shares are a type of preferred shares a corporation can or must buy back from shareholders at a predetermined price. The call date and price of redemption are detailed in a prospectus before the offering.
When choosing between repurchasing common shares and redeeming preferred shares, companies consider all available financing options to achieve an optimal capital structure. Falling interest rates provide incentive for share redemption if the cost of debt falls below the fixed preferred dividend yield. In a high interest rate environment, preferred shares might provide the lowest cost of capital, leading companies to repurchase undervalued common stock rather than redeem preferred shares.
The relative cost of dividends is another important factor. Common dividends usually increase or decrease with earnings. Preferred stock may be a cheaper financing option for an undervalued company that has experienced earnings growth since issuing preferred shares.
Consider a hypothetical company that issues preferred stock in year one. The stock can be redeemed for Rs 100 per share and pays an annual dividend of Rs 8. At the time of issuance, market price for the company’s common stock was Rs 120, and it paid a dividend of Rs 7 per share annually. Suppose in year two, the company experienced earnings growth and is paying a common dividend of Rs 9 per share. The company appointed a promising new CEO who has the full confidence of the board of directors, but investors are worried about the CEO’s lack of experience. This uncertainty drives share prices to Rs 100 in year two, and the company believes common shares are undervalued. Each Rs 100 spent on common share repurchase saves Rs 9 per year on dividend payments, while each Rs 100 spent on preferred stock redemption saves the company Rs 8 per year on preferred dividend payments.