Question

How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock?

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Answer 1

Hi,

Background: All these terminologies like common equity, debt and preferred stock are associated with capital of any firm. To begin with, whenever a firm is established (any company, entrepreneurial activity, startup etc.) - it needs money/funds to manage day to day operations and perform intended activity. This money can be called as capital of the firm.

Capital structure: Capital structure defines the composition of funds raised through various sources. The firm can raise money through different sources, most common sources are as follows:

1. Common Equity - Refers to own money, borrowed money through friends/relatives, shareholders money if its publicly listed, venture capital or private investment for startup etc. Common equity is like part ownership in firm which possess voting rights and claim on profits in the form of dividends. This claim is post payment of debt holders and preferred shareholders. I will illustrate it with example below.

2. Debt - Refers to loan in simple language. Normally debt holders are banks/large institutions/financial intermediaries. They lend you money for fixed/pre agreed interest rates. They dont have voting rights in firm. Irrespective of profit/loss, firm is obliged to pay interest amount to debt holders.

3. Preferred Shares - Refers to fund raising which has features of both common equity and debt, its a hybrid instrument.

3.1 Similarity with debt holders - Preferred shareholders earn regular & fixed/floating payments similar to debt (also known as preferred share dividend); however generally the payments is lower compared to debt holders.

3.2 Similarity with common equity - Preferred shareholders possess ownership in firm such that they have higher claim on firm assets compared to equity shareholders. Unlike equity, they dont have voting rights. Its considered less risky than common equity because of regular payments and protection in case of liquidation or bankruptcy.

In case of bankruptcy, firm is obliged to pay debt holders first, then preferred share holders and lastly common equity.

First Question: Example - A firm has a capital of $100 in year 1 with a composition as equity $50, preferred share $20, debt $30. Firm has promised 10% interest to debt holders and 5% dividend payment to preferred shareholders on annual basis.

Case 1: In year 2, firm earned 30% returns (equivalent to $30 = $100*30%) -> Formula - Capital * Returns%

Payment to debt holders - $3 (30*10%) -> Formula - Debt amount * Returns%

Payment to preferred shares - $1 (20*5%) -> Formula - Preferred amount * Dividend%

Remaining to common equity - $26 ($30 - $3 - $1 = $26) - > Formula - Total return - debt payment - preferred share payment

In this case all shareholders were able to earn positive returns due to higher returns.

Case 2: In year 2, firm earned 5% returns (equivalent to $5 = $100*10%)

Payment to debt holders - $3 (30*10%)

Payment to preferred shares - $1 (20*5%)

Remaining to common equity - $1 ($5 - $3 - $1 = $1)

If you look at this example, common equity returns came down from $26 to $1 because of fluctuation in firm returns, Considering volatile and uncertain nature of common equity its consider more risky than preferred shares and debt holders.

This answers first and second question.

Third question - floating rate preferred stock is special category of preferred stock where dividend rate is reset at regular intervals using some formula which is predefined. Dividend rate is variable in this case. To determine dividend rate, some benchmark is used to have minimum possible dividend every time. This gives firm flexibility to adjust dividend rate for preferred shareholders based on company profits and economic scenario. Compared to fixed rate preferred shares, this category is considered slightly risky due to variability in returns. In good times, they may earn higher than fixed rate preferred shareholders and in bad times they might have to suffer compared to fixed rate preferred shareholders.

Note: I hope this is helpful to get a detailed understanding of preferred shares and its interaction with other forms of capital structure like common equity and debt. Kindly write in comments in case of any additional concerns.