HYBRID SECURITIES Preferred Stock Preferred stock is a hybrid instrument; it is like debt but it is also like equity.

The dividends on preferred stock are generally set at a specific dollar amount per share, often expressed as a percentage of par value. There is also dividend preference the company cannot pay any common stock dividends until the preferred stock dividends have been paid. Typically, preferred stock dividends are cumulative so that all dividends in arrears on preferred stock must be paid before common stockholders can be paid anything. It is not uncommon that dividends in arrears also carry an interest rate that accumulates. In the event of liquidation, preferred shareholders will be repaid the par value of the preferred stock. While the standard type of preferred stock pays a constant dividend and never matures, there is a wide variety of provisions that may be included in a preferred stock issue: Sometimes the preferred stockholder get to vote. There may be a maturity date and sinking fund provision. Sometimes there is a call provision. On rare occasion, there is what is known as participating preferred stock that participates in the profits up to a limit during unusually good years. Very often the preferred stock is convertible into common shares. Many times the ability to vote is linked to the conversion feature and the preferred stockholders can vote as if they had converted into common stock.

You will often see preferred stock used in small companies that need to raise additional capital. The investors, typically venture capitalists, will invest money in the form of convertible preferred stock. Thus, if the company prospers and the common stock becomes worth a significant amount, the investor can convert to common stock and cash in on the companys good fortunes. On the other hand, if the company ultimately founders or fails, the investor is first in line to get paid dividends or to be repaid from any proceeds that remain after liquidation. Advantages of Preferred Stock to the Investor Relatively steady income (relative to common stock). Preference over common stock in liquidation. Dividends paid to corporations owning the preferred stock are excluded from income to as much as a 70% extent.

Disadvantages of Preferred Stock to the Investor Returns are limited. There is no enforceable right to dividends (unlike interest payments that must be paid annually).

There is high risk due to price fluctuations. Recall from our discussion of valuation of securities that preferred stock is a perpetuity and perpetuities are the most sensitive to changes in interest rates.

Advantages of Preferred Stock to the Company There is no fixed charge that must be paid each year. There is no maturity. No dilution of control (unless convertible). The cost is less than the cost of common equity. While the first two advantages are the same as the advantage of using common stock, the cost is less. Why? Because the risk to the investor is less than that of common stockholders.

Disadvantages of Preferred Stock to the Company Cost is higher than debt. Dividends are not tax-deductible.

From the perspective of a bondholder, preferred stock is like common equity. It provides for more assets that generate income that is used to pay lenders their interest first and provides more asset that can be liquidated to pay lenders their principal first if the firm goes bankrupt. From the perspective of a common stockholder, on the other hand, preferred stock is like debt. The preferred stock dividends must be paid first (and also act as leverage in terms of magnifying the variability of income) and the preferred stockholders are ahead of the common shareholders in the event of liquidation (just like lenders). Preferred Stock Valuation The classic version of preferred stock is a share that pays a fixed dollar amount of dividend and never matures. It is, therefore, a perpetuity. The formula for the value of a share of preferred stock is
Value of Preferred Stock = Dividend rp

Since the plain vanilla type of preferred stock is a perpetuity, its value is very sensitive to changes in interest rates.