Question

What are the benefits that common stockholders may receive? How do common stock and preferred stock differ? Discuss the similarities between preferred stock and debt. Why do corporations utilize different forms of equity?

Answer 1

Benefits that common stockholders receive-

1) Investment Appreciation - The value of common shares tend to increase over time as owning common stock of a company is essentially participating in its growth. The common stockholders can derive health returns in terms of dividend and capital gains due to the appreciation of the value of the stock in the capital market.

2) Voting Rights- Holding common stock of a company is equivalent to being one of the many owners of the company. Common stockholders get voting rights in major decisions such as selection of the Board of Directors.

3) Limited Liability- The stockholder has limited liability with regards to dues against the company, which is limited to the amount unpaid on the stock. Owner of fully paid up stocks have no such liability. This advantage is not exclusive to common stockholders but available to preferred stockholders as well.

Difference between Common Stock and Preferred Stock

1) Voting rights- Common stockholders, being the owners of the company, enjoy voting power in various decisions. Such a right is not available with preferred stockholders.

2) Dividend- Dividend to common stockholders is not fixed and is at the sole discretion of management. Dividend to preferred stockholders is fixed as defined by the instrument itself.

3) Preference of dividend- The company cannot pay a dividend to common stockholders without paying the dividend to preferred stockholders. However, a dividend can be paid to preferred stockholders without paying the dividend to common stockholders.

4)Callable- Preference shares can be callable at the option of the company. However, the company cannot exercise such powers with common stock.

5) Liquidation- In event of liquidation, preferred shareholders are given priority of settling dues over common stockholders.

6) Volatility- Common stock is more volatile in the market in comparison to preferred stock. This increases the return and risks associated with common stock.

Similarities between preferred stock and debt

1) Fixed return- The return earned on preferred stock is fixed by dividend and on debt is fixed by interest. The return is usually the coupon rate applied on the face value of the preferred stock or debt.

2) Convertible- Debt instruments, as well as preferred stocks, can be issued with an option of conversion into common stock at a later stage.

3) Callable- Similarly, debt instruments, as well as preferred stocks, can be issued with an option of being called by the company at a later stage.

4) Volatility- Due to the factor of fixed income, preferred stock and debt have low volatility in the market, making them a less risky option to invest in.

5) Liquidation- In event of liquidation, the liability to debt holders and to preferred stockholders is at priority as against liability to common stockholders. (However, debtholders enjoy priority over preferred stockholders)

Reasons for corporations utilizing different forms of equity-

1) Attract more investment- The primary purpose of issuing equity is to raise funds from investors. Each investor has different expectations from their investment. Risky investors may prefer common stock to have a prospect of higher returns. On the other hand, some investors may want to invest in preferred stock to limit the volatility and enjoy a continuous stream of cash flows. Having different forms of equity ensures that objectives of different types of investors are satisfied, thus enabling the company to raise more capital.

2) Balance the risk- From the company's point of view, they cannot issue preferred stock in excess of their paying capacity as it carries more risk for the company as against common stock, where payment is at the discretion of the management. Also, preferred stock can be redeemable, which makes it riskier for company as they need to ensure sufficient funds when the redemption becomes due. Such risks are not associated with common stock

3) Dilution of control- Since common stock carry voting rights with them, the company cannot issue an excess amount of common stock as it may result in dilution of control of the promoters. Hence to reduce the risk, preferred stock is issued in conjunction with common stock.