preferred stock advantages and disadvantages

preferred stock advantages and disadvantages

What are the advantages and disadvantages of preference shares?

Preference shares carry a number of benefits for both companies and investors. The chief benefit for shareholders is that preference shares have a fixed dividend that must be paid before any dividends can be paid to common shareholders. While dividends are only paid if the company turns a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. Once the business is back in the black, all unpaid dividends must be remitted to preferred shareholders before any dividends can be paid to common shareholders.

In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim on company assets than common shareholders. This makes preference shares, also called preferred shares, particularly enticing to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are compensated for their investments sooner.

Other types of preference shares carry additional benefits. Convertible shares allow the shareholder to trade in preference shares for a fixed number of common shares. This can be a lucrative option if the value of common shares begins to climb. Participating shares offer the shareholder the opportunity to enjoy additional dividends above the fixed rate if the company meets certain predetermined profit targets. The variety of preference shares available and their attendant benefits means that this type of investment can be a relatively low-risk way to generate long-term income.

From the investor's perspective, the main disadvantage of preference shares is that preferred shareholders do not have the same ownership rights in the company as common shareholders. The lack of voting rights means the company is not beholden to preferred shareholders the way it is to equity shareholders, but the guaranteed return on investment largely makes up for this shortcoming. However, if interest rates rise, the fixed dividend that seemed so lucrative can quickly look like less of a bargain as other fixed-income securities emerge with higher rates.

Preference shares also have a number advantages for the issuing company. The lack of shareholder voting rights that may seem like a drawback to investors is beneficial to the business because it means ownership is not diluted by selling preference shares the way it is when ordinary shares are issued. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing common shares. Issuing preference shares carries many of the benefits of both debt and equity capital and is considered to be a hybrid security.

Companies can also issue callable preference shares, which afford them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital. Shareholders, however, would consider this a disadvantage.

The chief disadvantage to companies is the higher cost of this type of equity capital relative to debt. However, financing through shareholder equity, either common or preferred, lowers a company's debt-to-equity ratio, which is considered by both investors and lenders to be a sign of a well-managed business.

The Advantages and Disadvantages of Preferred Stocks

The Advantages and Disadvantages of Preferred Stocks

Concerned investors looking to protect wealth and pick up yield have increasingly focused on fixed income. But it’s been a rough few years for yield-oriented investors, interest rates are low and the world is flooded in liquidity.

Preferred stocks have been around for over a century. They represent a piece of a company’s capital structure that is senior to the common shares, but subordinate to the debt. As with common stock, dividends aren’t guaranteed and must be declared by the board of directors, usually on a quarterly basis. The dividend is usually a specific dollar amount per share or a percentage of par/stated value. Unlike bonds, preferred stocks usually have no maturity date for when the principal is repaid. However, most can be called or redeemed by the issuer at a specific date and price.

Preferred status: Dividends must be paid on the preferred stock before they can be paid on the common stock. In a sale, liquidation or bankruptcy reorganization, the interests of the preferred holders usually come ahead of those of the common stock holders, but behind the debt holders.

Liquidity: Most preferred stocks trade on the NYSE or NASDAQ in round lots of 100 shares, making them easier to purchase than bonds, which trade in lots of $5,000 to $10,000.

Accumulation: Most, but not all, preferred stocks is cumulative, meaning if a full dividend is not paid each quarter, it accumulates indefinitely until paid. No common stock dividends can be paid until preferred dividends in arrears are paid. A Holder of cumulative preferred stocks may not receive dividends for a quarter or even years. Then, should the firm’s fortunes improve, the cumulative dividends will be paid. Some investors buy “broken” preferred stocks. These securities pay no dividends, but trade at big discounts to par/stated value; investors will hold them until the arrearage is cured. The shares normally rebound once dividend payments resume.

Tax advantages: Currently, preferred dividends are taxed at an appealing 15%, but that rate part of the Bush tax reduction, dividends of all types will be taxed as ordinary income if Congress does not act.

Minimal voting rights: Preferred owners can rarely elect directors. However, if the firm wants to issue senior securities, merge, or fundamentally alter the firm’s financial structure; the preferred owners usually have the right to vote on these matters.

Callability: Almost all preferred stocks are callable at par/stated value at the issuer’s option, normally at a specified price after a specified time from issue date (usually five years). In the declining interest rate environment of recent years, many preferred stocks have been called, leaving holders with the challenge of replacing a high-dividend income stream. Companies are constantly looking to lower their cost of capital, and refinancing a high-cost preferred is one of the most logical ways to do this.

Interest rate risk: Like most fixed-income vehicles, existing preferred stocks will rise in price if interest rates fall and decline in price if interest rates rise. While there appears to be minimal evidence that rates are about to rise sharply, preferred owners should realize that risks increase as yields rise. Investors are best off buying preferred stocks in a stable or declining interest rate environment and avoiding them if rates are about to rise.

Credit risk: Deterioration in a company’s fundamentals could inhibit the ability to make preferred dividend payments. An issuer will eliminate a preferred dividend before it will default on its debt. Many preferred stocks are rated by Moody’s and/or Standard & Poor’s and investors should stick with preferred stocks that are rated investment grade (Baa/BBB) or better. A ratings downgrade is a sign that trouble may be brewing.

8 Big Advantages and Disadvantages of Common Stocks

Common stocks are securities that give you equity ownership in a corporation. As a common stocks holder, you will have voting rights and a share of the company’s dividends and/or capital appreciation. As a mere investor, however, you are at the bottom of the priority ladder. If the company goes bankrupt, you will only receive your money after debt holders, bondholders and preferred stockholders have been given their share.

This makes common stocks riskier compared to preferred stocks or debt shares. But because it performs better than bonds and preferred shares over time, it provides certain advantages. This only shows that common stocks are associated with pros and cons. How good or bad the situation is for you, depends on which side of the spectrum that you are in — whether you are investing on common stock or issuing it.

List of Advantages of Common Stocks

As already mentioned, common stocks often outperform bonds, deposit certificate and other types of investment products. As they are guaranteed, what you stand to gain has a minimum and a maximum. Common stocks, on the other hand, have no limits to the amount of money that you will gain. Although there is always a risk of losing, you are also guaranteed of earning large gains. This is something every investor wants and needs.

A company issuing common stocks in the financial markets use them as an alternative to debts, as it is a less expensive route. Unlike debts, an issuer of common stocks is not obligated to pay interest to investors, only discretionary payments on dividends in the event that the company has extra cash.

With this type of financial vehicle, you are only allowed to invest with limited liability. That is, whatever amount you invested initially would be the most that you will lose in the event of liquidation. And because you purchase common stocks on cash basis, you can put a cap on the amount of money to invest. Compared to leverage transactions, you are not at risk of losing money that exceeds the total funds you have invested.

3. Legal liabilities are restricted.

Since you are a passive holder of common stocks, your liability to a company is limited. Whatever problems that arise outside a stockholder’s financial investment, you will not be affected. Only the people running the company would have to face the consequences. The only thing you should be worrying about is the company’s health. As long as it is earning and moving on an upward trend, your investment and financial future is safe.

4. Easy buying and selling process.

As this type of investment is liquid, you have the option to sell it any time you want, or buy more if you wish to grow your stocks. What is even better is that common stocks can be purchased at a fair price.

5. There are two ways to gain benefits.

Capital gains and dividends are two ways to earn from stocks. Each stock you own gives you a cut of whatever a company earns since you are a partial owner. If the value of the stock appreciates, so will the capital gains. If the business’s earnings go beyond what it needs to cover maintenance and growth, it has the option to distribute the excess to holders of common stocks, or make dividend payments.

List of Disadvantages of Common Stocks

Risks are always associated with investing, but more of these are linked to common stocks. Their prices are volatile, fluctuating erratically. If you panic every time the price goes down and sells your stocks, you could end up losing more. The value of the stocks can also change without warning, making it difficult to evaluate their performance even if the company is doing well. Worse, if the business goes bankrupt, you can say goodbye to your investment.

Buying stocks from a company is a tricky situation. Your success practically depends on whether or not a business has excellent practices and strategies. Since you have no right to demand a copy of their books or business plans, you would have to do your research in other ways. As a shareholder, you are also subject to the will of stockholders. You cannot join in the decision-making process or suggest a better way of doing things. Therefore, if stockholders don’t do their jobs well, you could go down with them. This is why it is vital that you perform due diligence before you invest.

There is one way to have some control, however. You have to buy a significant amount of shares to gain a majority in the investment. Unfortunately, not everyone will be able to afford this. Moreover, companies usually put a cap of the number of common stocks they sell to keep the control of existing shareholders strong.

This is probably the biggest downside of common stocks. As previously mentioned, if a company liquidates, you would not get paid until those that rank high on the priority ladder gets their share. Good enough if you get to pull out your stocks just in time. But because stocks don’t always behave as consistently, anticipating its performance would be difficult. You can only hope that you do get paid, after everyone else does, including the creditors, employees, suppliers and taxes.

On the side of an issuing company, selling too many common stocks can have a negative impact on the existing shareholders. It is bad news if the business keeps increasing its outstanding shares. According to the Wall Street Journal, the ownership of shareholders and voting influence will diminish when the stocks enter the market.

When it comes to common stocks, getting the companies right is just as important as getting the price right. The best combination would be to buy stocks at a fair price from a company with a strong and longstanding reputation in the market. Unfortunately, the stock market is not always cooperative. Or make that rarely cooperative. This is why timing and research are very important.

Advantages and Disadvantages of Stocks

Bonds and stocks dramatically differ in their payouts, structures, risks and returns. Bonds are a form of debt in which a person is the lender instead of the borrower. A bond is a contractual loan made between the institutions and investors that, in return for financing, pay a premium for borrowing likely known as coupons. Moreover, the face value of bonds is returned to the investor at its maturity. The payback guarantee and all payments of coupon solely rely on the borrower’s ability to generate sufficient cash flow to reimburse bondholders.

A stock is a type of ownership as they represent contribution to a company’s growth. Normally, investors are given no promises about any returns of the initial investment. Indeed, the investment profitability depends almost entirely upon rising stock price, which, at the most essential level, directly relates to the growth and performance of the company.

  • The stock rate is bound to rise and fall on a daily basis, but if a person looks at his previous records, stocks have proven to be essentially beneficial for its investors.
  • The best part about stocks is that most of them are liquid. This implies that they readily can be sold or bought at a fair price.
  • As investors, if you bought stocks, you can get a break to participate in the growth of the company. Moreover, if you buy stocks of a particular company, you are entitled to the profits made by them since you are a partial owner.
  • The potential loss from stock bought with cash is quite limited to the overall amount of the initial investment. It is better than considerably that of some leveraged transactions, where maximum loss is observed and exceeds the overall funds invested.
  • Stocks have the potential of delivering huge amounts of gains compared to certificate of deposit, bonds or other alternatives.
  • It also offers 2 ways for their owners to benefit, with dividends and by capital gains.
  • Sometimes, stock values change for no apparent reason that can be quite frustrating for the investor who’s trying to anticipate the behavior of the stock based on the actual performance of their company.
  • Prices of stocks tend to be volatile as well. Prices can be rising, erratic and declining fast. Such declines sometimes cause investors to sell and panic, which actually serves only to lock in their losses.
  • Investors in a certain company might not know all that there is to know about their company. Due to this insufficient information, making an investment decision is sometimes hard.
  • While shareholders are company owners, they don’t enjoy all of the privileges and rights that the owners of privately held companies have. For an instance, they can’t normally brag in and ask for the company’s current books and details.
  • Stockholders are also the last one to get paid since the company should pay first their employees, creditors and suppliers. They have to pay their taxes as well.

Advantages & Disadvantages of Preferred Stock & Bonds

Deciding to invest is a huge financial step, not something to be taken lightly - Advantages & Disadvantages of Preferred Stock & Bonds introduction. In deciding which method, stock or bonds, one has to look at all the angels- the advantages and disadvantages, both immediate and long term. Preferred stock has many advantages and disadvantages. Unlike debt, preferred stock is flexible. Meaning preferred stock can miss annual payments unlike typical debt. Preferred stock not only is more flexible, it also helps increase financial advantage of companies.

Preferred stock also helps corporations restructure themselves. However, the disadvantages far outweigh the advantages. Common stockholder’s are below preferred stockholders, which means returns for common stockholder’s are always in jeopardy. Preferred Stock generally has a higher cost then debt financing as well. Preferred Stock is also harder to sell, since payments of dividends are not guaranteed. The stock is also restricted by issuing company’s policies, guidelines and qualifications unlike bonds.

More Essay Examples on Finance Rubric

The major problem with Preferred Stock is the tax implications and the fact that companies are not obligated to pay stockholder’s dividends- those leaving Preferred Stockholder’s empty handed. Another investment option is Bonds. Bonds are the “safe” way to invest. Bonds are predictable. Interest amount, principal amount, how often paid and maturity date are all known ahead of time. Bonds provide a steady and regular income (monthly/quarterly/semiannual payments).

The interest rates on bonds usually exceed those of banks saving accounts. However, because bonds are based on a company’s finances (ability to repay loans), there is always the risk the company who issues the bond can go bankrupt, leaving the bonds either worthless or less than original value. Bonds provide no opportunity for high long term return and the long term money in bonds are tied up in low interest rate for an extended period. Bonds are the most recommended when looking to invest or issue anything (stock or bonds).

I’d recommend going with Bonds, because unlike Preferred Stock, unless a company goes Bankrupt, there is a guaranteed salary. Bonds are recommended for people who need a steady and dependable income. As people get to retirement age, bonds reduce the investment risk, making them highly desirable. Bonds are also recommended for people looking to help specific causes (school, patriotic duties, etc. ). Bonds have less disadvantages then Preferred Stock, and pose lesser risk for the investor making Bonds the way to go.

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