Question

3. The preferred response will include an explanation in your own words, and a good example.

From the point of view of an issuing corporation, please describe the primary advantages and disadvantages of issuing preferred stock.

Answer 1

Preferred stock or preference share capital are the stocks issued by a company are usually a mix of features of both equity stocks and bonds. Just like bonds they carry a regular interest at a fixed rate and dividends are payable just like equity stocks. There are a variety of preference shares carrying relatively low risk for an investor and can be a source of a regular income.

From the point of view of issuing company primarily these stock are issued so that the ownership of the company is not diluted as these shareholders don’t have voting rights. The following types of preferred stocks are there carrying their own advantages and disadvantages –

1. Prior preferred stocks

2. Preference preferred stocks

3. Convertible preferred stocks

4. Participating preferred stocks

5. Cumulative preferred stocks

While the following are the common advantages and disadvantages of preferred stocks –

Advanages –

1. Primarily issuing a debt for employing capital in business increases the debt equity ratio of the company. It is an important measure for the investors which makes the company financially attractive for them. While preferred stocks carry features of both equity and debt funds they are primarily taken into consideration as equity. Thus maintaining a favourable debt equity ratio.

2. Even though the preferred stocks are taken as a part of equity, the owners of preferred stocks do not carry any voting right and are not part of controlling stake. Thus it prevents the dilution of ownership of business.

3. A preferred stock could be more advantageous for a company when the companies rate of return on its investment is higher than the rate of interest of preferred stock. For example if a company is earning a rate of return of 20% on its investment and the preferred stock are offered an interest of 12%, then the remaining 8% would be a profit to the company which will ultimately reinvested by them and will form a part of earning of common stock holders.

Disadvantages –

1. Preferred stock are obviously preferred for a reason and the reason being the low risk and continuous return to the investor which will continue to occur to the company even if its earning no profits or losses. Thus a preferred stock can be a continuous increasing debt for the company at times.

2. In case the company went into liquidation the preferred stock holders have a higher claim on the companies assets as they lie just after debenture holders to recover their capital invested along with the interest occurred and thus have a higher risk liability than common stock holders for the company which will be liable even if it went into liquidation.

3. While the abovementioned parameters are tough for the company to handle, practically selling preferred stocks are not easy. In a continuously changing and a volatile market the preferred stocks offer an investor a relatively higher period of maturity which is usually more than a decade and thus becomes unattractive to an investor who want his funds to grow while having a relatively lower period of maturity.