Question

Preferred stock is said to be a hybrid of common stock and bonds. Explain fully. Describe the cash flows associated with preferred and their valuation

Answer 1

Preferred stock or sometimes the term preference shares is used. They are called a preferred stock as they entitle the holder to certain preferential rights. They receive a fixed amount of dividend and takes priority in payment in the event of winding up. The dividend of the holders of the preferred stock cannot be waived off, it acts as a liability, unlike the dividend of common stock holders which can be revoked or not paid in the situation of losses or shortage of funds. The holders of these shares do not get voting rights, it neither represent the ownership in the company nor its a debt that has to be repaid

Preferred stock is said to be hybrid as it has the properties of both, common stock and a debt. The dividend a preferred stock pays is fixed, as is the interest amount a bond pays. The percentage rate of the dividend is usually higher than common stock dividends and often compares favorably with bond interest rates.

The risk associated with preferred stock is always low as compared to the common stock. If a company is liquidated, bondholders and other creditors are paid first. Preferred shareholders must be paid next, before any distribution of company assets is made to common stock shareholders.The manner in which preferred stock prices fluctuate is very similar to what you see for bonds. This is because investors view preferred stock as an income security like bonds. Preferred stock suits the requirements of a less agressive investor, who has a low risk appetite.

Cash Flows Associated:   Money raised and payments made to the preferred stock holders forms part of the financing activity. Any payments made to the preferred stock holder as dividend reduces the the cash with the company and so depicted as negative figure in the financing activity of the cashflow. The cash expenses included with the preferred stock is legal expenses, dividend/interest payments etc.

Valuation: The value of the preferred stock depends upon the future dividends generated. The most common method of valuing the stock is taking the present value of the future dividends upto a given time. Mostly the preferred stocks are perpetual in nature, due to the perpetual nature of preferred stock, the fixed periodic dividends form a perpetuity. Where the preferred stock dividends grow at a constant rate g, its value equals the present value of a growing perpetuity.

Formula used=

VP =	DP	=	P × dp
	kp		kp

Vp is the value of preferred stock

P is the par value of stock

Dp is the dividend ratio or annual dividend per share

Kp is the required rate of return