KWAME NKRUMAH UNIVERSITY OF SCIENCE AND TECHNOLOGY

SCHOOL OF BUSINESS
POST GRADUATE (MBA FINANCE PART TIME 2/ EVENING)

ACF 683: CORPORATE FINANCIAL STRATEGY

SUBMITTED TO: PROFESSOR JOSEPH MAGNUS, FRIMPONG
INDIVIDUAL ASSIGNMENT 1

QUESTION
TO WHAT EXTENT WOULD YOU CONSIDER PREFERRED STOCK AS EQUITY OR AS
DEBT?

BY
NAME: INDEX NUMBER: REFERENCE NUMBER:
KOFI BROBBEY PEPRAH PG3954220 20738677
Introduction

Preferred stocks are also known as “preference shares” are securities that represent ownership in
a corporation, and that have a priority claim over common shares on the company’s assets and
earnings. The shares are more senior than common stock but are more junior relative to bonds in
terms of claim on assets. Holders of preferred stock are also prioritized over holders of common
stock in dividend payments. In Accounting, according to IAS 32, preference shares can be
classified as equity, liability, or a combination of the two. Preferred stock is therefore a hybrid and
falls between pure equity and pure debt.

Preferred shares are typically issued with an assigned par value. Along with a stated dividend rate,
this par value defines the amount of the annual dividend promised to preferred shareholders.
Preferred share terms may provide the issuing company with the right to buy back the preferred
stock from shareholders at a pre-specified price, referred to as the redemption price. In general,
the pre-specified redemption price equals the par value for a preferred share. The par value of a
preferred share also typically represents the amount the shareholder would be entitled to receive
in a liquidation, as long as there are sufficient assets to cover the claim.

Features of Preferred Shares

Preferred stocks have a special combination of features that differentiate them from debt or
common equity. Although the terms may vary, the following features are common:

1. Preference in assets upon liquidation:

Liquidation preference: In the event of any liquidation, dissolution, or winding up of the Company,
the holders of the Preferred Stock shall be entitled to receive, in preference to the holders of
Common Stock, an amount equal to the Original Purchase Price plus any declared but unpaid
dividends thereon. The remaining assets legally available for distribution, if any, shall be
distributed pro rata to the holders of the Common Stock.

2. Dividend payments:

The shares provide dividend payments to shareholders. The payments can be fixed or floating,
based on an interest rate benchmark such as LIBOR. Preferred shareholders have a priority in

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dividend payments over the holders of the common stock. However, preference shares are
attractive to investors due to corporate tax exemptions on preferred stocks.

3. Non-voting:

Preference shares do not, as a rule, entitle holders to a vote in the running of the company. The
general understanding is that, because preference shareholders receive a regular and fixed
dividend, they do not require voting rights. This is not always the case, and certain issues do entitle
holders to a vote.

4. Convertibility to common stock:

Preferred shares may be converted to a predetermined number of common shares. Some preferred
shares specify the date at which the shares can be converted, while others require approval from
the board of directors for the conversion.

5. Callability:

The shares can be repurchased by the issuer at specified dates.

Types of Preferred Stock

Preferred stock is a very flexible type of security. They can be:

 Convertible preferred stock:
The shares can be converted to a predetermined number of common shares.
 Cumulative preferred stock:
If an issuer of shares misses a dividend payment, the payment will be added to the next dividend
payment.
 Exchangeable preferred stock:
The shares can be exchanged for some other type of security.
 Perpetual preferred stock:
There is no fixed date on which the shareholders will receive back the invested capital.
Preferred Stock as Debt in Disguise

Preferred stocks are indeed applicable to debt hence can be described as “equity bond”. Preferred
stocks exhibit the features of debt as its payout dividends are fixed. Just as debt, preferred stock
prices fall as interest rate rise because their future cash flow is discounted at a higher price rate,

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offering better yield. On the other side, when interest rate fall, future cash flow is discounted at
lower prices hence preferred stock prices rise.

Preferred stock is similar to debt due to its callabity feature. Just as bonds, preferred stocks can
have embedded call option that gives the issuer the right to call back the security in case of a fall
in interest rates and issue fresh securities at a lower rate. Preferred stock offers the holder no voting
rights in the company as debt.

Preferred stocks have a very limited scope for capital appreciation because they have a fixed
payment that does not benefit them from the firm’s future growth. Both preferred stock and debt
may offer the option of allowing investors to convert the bonds or preferred into a fixed number
of shares of the common stock of the company, which allows them to participate in the firm’s
future growth.

Preferred Stock as an Equity

Preferred stock is equity because it shares represent an ownership stake in a company. Though
preferred stock holders under normal circumstance do not have a voting right, however, in an
extraordinary event preferred stock holders may be allowed to vote and that qualifies it to be
equity.

While preferred stock is technically equity, its particular terms may lead it to be treated more like
debt for regulatory capital or tax purposes. For example, rating agencies often decline to give full
equity credit for preferred stock that is mandatorily redeemable or the dividend obligation of which
is cumulative.

Conclusion

Since preferred stocks are not debt, companies that offer preferred shares instead of issuing bonds
can accomplish a lower debt-to-equity ratio. That allows them to gain significantly more future
financing from new investors. Preferred stocks are hybrid securities that have the characteristics
of both bonds and stocks. Though preferred stocks are classified under equity it is also a debt in
disguise and can therefore be termed as “Equity bond”. (Magnus)

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