PREFERRED STOCK: A HYBRID FORM OF CAPITAL
Preferred stock is a security that, similar to debt, promises a well-defined (specified) but not necessarily constant contractual cash flow (dividend) to the holders of the security. Unlike debt, it does not cause the firm to be subject to bankruptcy if the dividends are not paid. The term preferred stock implies that this security is in a more favorable position than the common stock. This conclusion is not likely to be valid for an individual investor paying taxes at a high rate on dividends. A corporate investor might like preferred stock because of a70%“dividend-received deduction”. The corporate tax savings associated with interest on debt make it difficult for preferred stock to compete with debt in the non-regulated sector of corporate activity. Also, the capital gains and tax deferred possibilities for individual investors of common stock give common stock tax advantages over preferred stock with a contractual dividend and little chance of capital gains. Preferred stock has historically been important to regulated public utilities, and it is likely to be approximately 10 percent of a typical public utility’s capital structure.
Preferred stock is a hybrid form of capital, possessing a mixture of debt and common stock characteristics. Like the interest on debt, its dividends may be fixed over time. However, “participating” preferred stock shares income with common stock according to some prearranged formula and other preferred stock may pay a dividend that is linked to some independent measure such as the yield on government bonds. Like common stock, preferred stock is generally treated as equity capital for corporate tax purposes, so its dividends are paid from corporate earnings that have been taxed. Preferred stock generally has a perpetual life, although it may have a finite life, and it may have a call price specified and even a sinking fund where stock is to be repurchased by the firm in the open market....
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