The Handbook of Financial Instruments

Chapter 12 Preferred Stock

Steven V. Mann, Ph.D.

Professor of Finance The Moore School of Business University of South Carolina

Frank J. Fabozzi, Ph.D., CFA

Adjunct Professor of Finance School of Management Yale University

Preferred stock is an equity security, not a debt instrument, but it combines features of both common stock and debt. The preferred stockholder is entitled to cash dividends paid by the issuing corporation. Unlike the cash dividends paid to common shareholders, however, cash dividends paid to preferred shareholders are fixed by contract, usually at a specified dollar amount or percentage of their par or face value. So, in its most basic form, a share of preferred stock can be thought of as a perpetuity—an endless stream of cash dividends. The specified percentage is called the dividend rate; it need not be fixed, but may float over the life of the issue.

Almost all preferred stock limits the payments to be received by the security holder to a specified amount. Historically, there have been issues entitling the preferred stockholder to participate in earnings distribution beyond the specified amount (based on some formula). For instance, a preferred stock may pay additional cash dividends after all common dividends have been paid. A preferred stock with this feature is referred to as participating preferred stock. However, most preferred stock issued today is nonparticipating in that the cash flows received will never exceed those specified in the contract ...