Preferred stock is a hybrid security — it has features of both a stock (it's equity, representing ownership) and a bond (it pays a fixed dividend like bond interest). Companies issue preferred stock to raise capital without diluting voting rights or taking on debt.
Think of it this way: If common stock is a general partnership where everyone shares equally in wins and losses, preferred stock is more like being a senior partner who gets paid first — but doesn't get to vote.
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Fixed Dividend Preferred shares pay a stated dividend (usually expressed as a percentage of par value or a fixed dollar amount). For example, a $100 par preferred paying 6% = $6/year per share.
This dividend is paid before any dividends can be paid to common stockholders. Preferred stockholders don't benefit when earnings soar — they get their fixed amount and that's it.
Priority in Liquidation If the company goes bankrupt: 1. Secured creditors 2. Unsecured bondholders 3. Preferred stockholders ← here 4. Common stockholders
Preferred stockholders get paid before common holders, but still after all creditors.
Typically No Voting Rights The trade-off for getting paid first: preferred stockholders usually give up their vote. The company retains control without preferred holders interfering in corporate governance.
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Cumulative Preferred If the company skips a dividend (called a "passed" or "omitted" dividend), those missed payments accumulate and must be paid in full before common stockholders receive anything.
> Example: A company skips preferred dividends for 2 years ($6/year). In year 3, before paying any common dividend, they must pay the $12 of arrears PLUS the current year $6 = $18 to preferred holders first.
Non-Cumulative Preferred Missed dividends are gone forever — they do NOT accumulate. This is riskier for the investor; the company can skip dividends and owe nothing in arrears.
Participating Preferred After receiving their fixed dividend, participating preferred holders can also share in additional profits with common stockholders up to a stated limit. Rare, but the Series 7 tests the concept.
Convertible Preferred Holders can convert shares into common stock at a preset conversion ratio.
> Example: 1 preferred share converts to 4 common shares. If preferred is priced at $100 and common is at $30, conversion gives you $120 worth of common — a $20 profit. You'd convert when it's advantageous.
Callable Preferred The company has the right to buy back (call) the preferred shares at a preset call price, usually at a premium to par. Companies call preferred when interest rates fall — they retire expensive preferred and re-issue at a lower rate. This hurts the investor because they lose their high-yielding security.
Adjustable Rate (Floating Rate) Preferred Dividend rate adjusts periodically based on a benchmark (like Treasury rates). Less interest rate risk than fixed-rate preferred.
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| Feature | Preferred Stock | Common Stock | Bond | |---------|----------------|--------------|------| | Income | Fixed dividend | Variable/none | Fixed interest | | Voting | Usually no | Yes | No | | Liquidation priority | Before common | Last | Before both | | Upside | Limited | Unlimited | None | | Obligation | Not guaranteed | Not guaranteed | Contractual |
Key distinction: Bond interest is a legal obligation — the company must pay it or face default. Preferred dividends are not — the company can skip them (especially non-cumulative). This is why preferred stock yields more than bonds of similar quality: higher risk = higher compensation.
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Because preferred stock pays a fixed dividend in perpetuity (like a perpetual bond), it's highly sensitive to interest rate changes:
This makes preferred stock behave more like long-term bonds than like common stock.
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Quiz Questions:
Q1. A company's cumulative preferred stock has a $4 annual dividend. The company skips dividends for years 1 and 2. In year 3, the company wants to pay a common stock dividend. What must happen first?
A) The board may declare a common dividend without restriction once profits resume B) The company must pay $4 (one year) in arrears before paying common dividends C) The company must pay $8 in arrears (two years) plus the current $4 before paying common dividends D) The arrears are forgiven after two years; only the current year dividend must be paid
Answer: C — Cumulative preferred arrears accumulate. Two missed years = $8 in arrears. Plus the current year = $4. Total $12 must be paid to preferred before any common dividend. This is why "cumulative" is favorable to preferred investors — unpaid dividends are not lost.
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Q2. An investor owns convertible preferred stock with a conversion ratio of 5:1 (each preferred share converts to 5 common shares). The preferred trades at $60 per share. The common stock trades at $14. Should the investor convert?
A) Yes — converting gives shares worth $70, which exceeds the $60 preferred price B) No — converting gives shares worth $70, less than the preferred par value of $100 C) Yes — conversion always benefits the investor regardless of price D) No — convertible preferred can only be converted at the issuer's request
Answer: A — Conversion value = 5 × $14 = $70 per preferred share converted. Since the preferred trades at $60, converting yields $70 worth of common — a $10 gain per share. The investor should convert. (Note: par value is irrelevant to this decision; market price is what matters.)
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Q3. Interest rates in the market rise significantly. Which of the following is the most likely impact on fixed-rate non-convertible preferred stock?
A) Preferred stock price rises because higher rates increase dividend income B) Preferred stock price falls because its fixed dividend is less attractive relative to new higher-rate alternatives C) Preferred stock price is unaffected because it is equity, not a debt instrument D) Preferred stock price rises because the company will call the shares at a premium
Answer: B — Fixed-rate preferred behaves like a long-term bond. When rates rise, newly issued securities offer better yields. The existing fixed preferred must fall in price until its yield is competitive. Companies do NOT call preferred when rates rise — they call when rates fall (to refinance cheaper).
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Q4. Which type of preferred stock offers the LEAST protection to investors in a company that frequently encounters financial difficulties?
A) Cumulative preferred B) Non-cumulative preferred C) Participating preferred D) Convertible preferred
Answer: B — Non-cumulative preferred does not accumulate missed dividends. If the company skips dividends, those payments are lost forever. The investor gets nothing in arrears. Cumulative preferred (A) protects investors by requiring all back dividends to be paid before common dividends resume.
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Q5. In the event of corporate bankruptcy, which of the following correctly describes the priority of distributions?
A) Common stockholders → preferred stockholders → bondholders B) Preferred stockholders → bondholders → common stockholders C) Bondholders → preferred stockholders → common stockholders D) All three receive equal distributions from remaining assets
Answer: C — Liquidation priority: secured creditors first, then unsecured bondholders, then preferred stockholders, then common stockholders. Preferred gets priority over common, but bondholders (creditors) always come before both equity classes. Common stockholders, as residual claimants, receive whatever is left — often nothing in bankruptcy.