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

Dividend
Value of Preferred Stock
rp

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