# Preferred Stock

Preferred stock is a class of a company's shares that have 'preferred' claim over the company's profits and net assets. They carry characteristics of both debt and equity instruments. They are similar to debt instruments in the sense that they normally have a fixed pay off which must be paid before any dividends are paid to the common stock holders. They are similar to equity instruments in the sense that in event of a company's winding up they share in the proceeds only after all the debts have been paid off.

## Comparison with common stock

They following characteristics of preferred stock make it different than common stock:

1. It does not carry any voting rights while common stock normally has considerable voting power that enable common shareholders to influence a company's decision.
2. It carries a fixed pay-off rate while the common stock has no guaranteed pay-off.
3. It has a preferred claim on the company's profit and net assets over the common stock. It means that dividends to preferred stockholders is paid before any payment is made to common shareholders. Also, in event of a company's winding up, preferred stockholders are paid off before any payment is made to common shareholders.
4. It is less volatile than common stock due the relative security of their periodic pay-off. Common stock on the other hand fluctuates with changes in market conditions and the company's outlook.

## Issuance of preferred stock

Preferred stock may be issued for cash or for some other consideration. Just like common stock, preferred stock may have some par value.

## Example 1

Company A issued 100,000 shares of preferred stock of $30 par value against$1,000,000 in cash and $2,000,000 worth of property, plant and equipment. They carry dividend of$3 per share.

The transaction is journalized as follows:

 Property, plant and equipment 2,000,000 Cash 1,000,000 Preferred stock ($30 × 100,000) 3,000,000 Where the issue price of preferred stock is different than its par value, the amount representing the par value is credited to the preferred stock account and the rest of the consideration is treated as additional paid-in capital. In practice there is considerable diversity in the way preferred stock issues are structured. Some of the sub-classifications of the preferred stock include participatory preferred stock, cumulative preferred stock, non-cumulative preferred stock, callable preferred stock, convertible preferred stock, etc. ## Participatory preferred stock While preferred stock mostly has a fixed percentage pay-off, in some cases it may have a component of payoff dependent on the profit of the company, such preferred stock is called participatory preferred stock. Another common feature of the participatory preferred stock is that it is entitled to participate in the liquidation proceeds of the company. ## Example 2 Suppose the shares in Example 1 above are entitled to participate to the extent of 10%. If the company's profit for the 10th year of issue is$1,000,000 before payment of preferred stock dividend, calculate the total preferred stock dividends for the 10th year. The company's common stock amounts to $10,000,000 and they will get total dividends of$1,000,000 million for the year.

Solution

Preferred stock in this example has two sources of dividends: first is the straight $3 per share dividend which amounts to$300,000 (i.e. $3*100,000), second is the dividend received through participation in the remaining profit. Profit after payment to preferred stock holders is$700,000 (i.e. total profit of $1,000,000 minus preferred dividend of$300,000). Preferred stock's participatory component of dividend amounts to $70,000 (i.e. 10% of the$700,000). Total preferred dividends pay-off for 10th year is $370,000 (i.e.$300,000 on the basis of fixed dividend and $70,000 on the basis of 10% participation). The participatory preferred stock also 'participates' in the excess liquidation proceeds. If the company defaults and is liquidated and the net assets realized (after pay-off of debts) amount to$15,000,000, preferred stock holders will receive two tranches from liquidation: first shall be the purchase value of the preferred stock i.e. $3,000,000; the second shall be 10% of the amount left over after all common stock holders are paid , i.e.$200,000 (10% of ($15 million minus$3 million preferred stock minus $10 million common stock)). Total liquidation payment to preferred stock holders shall be$3,200,000 ($3,000,000 plus$200,000).

## Cumulative preferred stock

Where the profit is not enough to cover the annual preferred stock pay-off, some preferred stock may have a provision to recover the dividends not paid in future periods, such preferred stock is called cumulative preferred stock. In case of cumulative preferred stock, dividends to common stock holders can't be paid until preferred dividends for the current and prior periods are paid.

## Example 3

Company A has $3,000,000 million issue of cumulative preferred stock comprising of 100,000 shares each carrying$3 dividend per annum. The company earned a profit of $200,000 in Year 1 and$500,000 in year 2. Determine the maximum amount of profit available for distribution to common shareholders.

Solution

 Year 2 Year 1 Profit $500,000$200,000 Less: preferred dividends for current year ($3*100,000) ($300,000) ($300,000) Less: preferred dividends for prior periods ($100,000) - Preferred dividends that could not be paid - $100,000 Profit available for distribution to common shareholders$100,000 -

You can see that $100,000 of preferred dividends could not be paid in Year 1 and the amount is carried forward and paid out of the next year profits before any distribution is made to common stockholders. ## Non-cumulative preferred stock Some preferred stock issues may not carry forward any interest short-paid or not paid, they are called non-cumulative preferred stock. ## Example 4 If the preferred shares mentioned in Example 3 above are non-cumulative, the profit available for distribution to common stockholders would be as follows:  Year 2 Year 1 Profit$500,000 $200,000 Less: preferred dividends for current year ($3*100,000) ($300,000) ($300,000) Profit available for distribution to common shareholders $200,000 - ## Callable preferred stock Callable preferred stock issues are those that may be retired at the option of the issuer. In such cases, the issuer pays off the whole amount of the preferred stock. ## Example 5 If company A pays off the$3,000,000 preferred stock at the end of 12th year, the transaction would be recorded as follows:

 Preferred stock 3,000,000 Cash 3,000,000

## Convertible preferred stock

Some preferred stock issues may carry a provision entitling the shares for conversion to common stock. They are called convertible preferred stock.

## Example 5

If Company A instead converts the 100,000 preferred shares to $10-par common stock on 2-for-1 basis, the transaction shall be recorded as follows:  Preferred stock 3,000,000 Common stock 2,000,000 Common stock-additional paid in capital 1,000,000 In a 2-for-1 conversion, 100,000 preferred shares shall be converted to 200,000 shares. If the stated value is$10 per share, credit to common stock account would amount to the product of the number of common shares issued and the par value. The difference shall be credited to the additional paid-in capital.

Written by Obaidullah Jan, ACA, CFAhire me at