What Is Preferred Dividend?

Preferred dividends are distributions from corporate earnings and profits paid to owners of preferred stock, taking priority over payments to common shareholders.

Preferred dividends are payments made by a corporation to its preferred stockholders from its earnings and profits. These distributions take priority over dividends paid to common shareholders, ensuring that preferred shareholders receive their dividends before common shareholders.

Characteristics of Preferred Dividends

Preferred dividends typically have the following characteristics:

• Priority of Payment: Preferred dividends must be paid out before any dividends are distributed to common shareholders.
• Fixed Dividend Rate: Preferred dividends often come with a fixed dividend rate, meaning shareholders receive a predetermined amount.
• Cumulative Feature: Many preferred stocks have a cumulative dividend feature, which means if a dividend payment is missed, it must be paid out in the future before any common dividends can be distributed.

Types of Preferred Stock

Cumulative Preferred Stock

Cumulative preferred stockholders are entitled to receive dividends in arrears if dividends are not paid in a particular period. These unpaid dividends accumulate and must be paid out before any dividends to common shareholders.

Non-Cumulative Preferred Stock

Non-cumulative preferred stockholders do not have the right to claim omitted or unpaid dividends in the future. If the company decides not to pay dividends in a given period, non-cumulative preferred stockholders have no claim to those dividends.

Participating Preferred Stock

Participating preferred stockholders have the right to be paid dividends equivalent to the specified rate of preferred dividends as well as an additional dividend based on a predetermined condition.

Convertible Preferred Stock

Convertible preferred stockholders have the option to convert their preferred shares into a predetermined number of common shares, usually at specific times and under certain conditions.

Example Scenario

Consider a corporation that has issued both preferred and common stock. If the corporation declares a dividend, preferred shareholders receive their dividend amount first. For instance, if a corporation declares a total dividend of $100,000 and has $50,000 in preferred dividends due, the preferred shareholders will receive their full $50,000 before any remaining $50,000 is distributed among common shareholders.

Historical Context

Preferred stock and dividends have been integral to the financial markets for centuries, providing a hybrid security that combines the features of debt (fixed returns) and equity (potential for capital appreciation). Historically, they have been attractive to investors seeking higher but stable returns compared to common stock.

Applicability in Corporate Finance

Preferred dividends are an essential consideration in corporate finance decisions as they impact the overall cost of capital. Companies may prefer to issue preferred stock to raise funds without increasing debt levels or diluting common equity.

FAQs

How are preferred dividends taxed?

Preferred dividends are generally taxed at the capital gains rate, which might be lower than the ordinary income tax rate, depending on the investor’s tax situation.

What happens if a company cannot pay preferred dividends?

If the company cannot pay preferred dividends, cumulative preferred stockholders will have their dividends accrue and owed in future payments, while non-cumulative preferred stockholders may lose their right to the unpaid dividend.

Can preferred stockholders vote?

Typically, preferred stockholders do not have voting rights, but some preferred stock may come with special voting rights under specific conditions.

References

1. Gitman, Lawrence J., Zutter, Chad J., “Principles of Managerial Finance,” Pearson.
2. Ross, Stephen A., Westerfield, Randolph W., Jordan, Bradford D., “Corporate Finance,” McGraw-Hill Education.
3. Brealey, Richard A., Myers, Stewart C., Marcus, Alan J., “Fundamentals of Corporate Finance,” McGraw-Hill Education.

Summary

Preferred dividends represent an assured form of income for preferred stockholders and offer a different risk-reward profile compared to common stock. These dividends reflect the hierarchy in the payout structure of a corporation, where preferred shareholders have an advantage over common shareholders. Understanding the intricacies of preferred stock and their dividends is vital for making informed investment decisions and corporate financial planning.