Preferred Stock: Videos & Practice Problems

Preferred stock represents a unique class of equity ownership in a company, distinct from common stock. While it is classified as equity, it shares some characteristics with debt, particularly in the way dividends are structured. Preferred stockholders receive dividends at a fixed percentage, which is typically based on the par value of the stock. This fixed dividend is a key feature that differentiates preferred stock from common stock, where dividends can vary based on the company's performance.

One of the primary advantages of preferred stock is the liquidation preference it offers. In the event of a company's liquidation, preferred stockholders are prioritized over common stockholders when it comes to repayment. After all liabilities are settled, any remaining assets are distributed to preferred stockholders before common stockholders receive their share. This ensures that preferred stockholders have a greater chance of recovering their investment in adverse situations.

Preferred stockholders also forfeit their voting rights, which means they do not participate in electing the board of directors. This trade-off allows them to enjoy the benefits of fixed dividends and liquidation preferences. The dividends for preferred stock are typically paid out before any dividends are distributed to common stockholders, reinforcing their preferential treatment.

When a company issues preferred stock, the accounting entries are similar to those for common stock. For instance, if a company issues 10,000 shares of $100 par value preferred stock at an 8% dividend rate for a total of $1,250,000, the cash received is recorded as a debit to cash. The preferred stock account is credited with the par value amount, which in this case is $1,000,000 (10,000 shares x $100 par value). The excess amount, which is $250,000, is credited to Additional Paid-In Capital (APIC) specifically for preferred stock.

The calculation of dividends for preferred stockholders is straightforward. Using the 8% dividend rate on the $100 par value, each preferred share would yield an annual dividend of $8. Therefore, for 10,000 shares, the total annual dividend would be $80,000. This amount is paid to preferred stockholders before any dividends are allocated to common stockholders, ensuring that their investment is prioritized.

In summary, preferred stock offers investors a blend of equity ownership with certain debt-like features, including fixed dividends and liquidation preferences. Understanding these characteristics is crucial for evaluating the benefits and risks associated with investing in preferred stock.

The Apartment Depot has two classes of stock: 10,000 shares of 8% preferred stock with a par value of $100 and 50,000 shares of common stock with a par value of 50¢. When the company declares a total dividend of $130,000, the preferred shareholders receive their dividends first, followed by the common shareholders.

To calculate the dividends for the preferred stock, we first determine the dividend per share. The preferred stock has an 8% dividend rate, which means each share receives:

$$\text{Dividend per Preferred Share} = \text{Par Value} \times \text{Dividend Rate} = 100 \times 0.08 = 8 \text{ dollars}$$

With 10,000 shares, the total dividend paid to preferred shareholders is:

$$\text{Total Preferred Dividends} = \text{Dividend per Preferred Share} \times \text{Number of Preferred Shares} = 8 \times 10,000 = 80,000 \text{ dollars}$$

After paying the preferred shareholders, the remaining amount for common shareholders is calculated by subtracting the total preferred dividends from the total declared dividend:

$$\text{Remaining for Common Shareholders} = \text{Total Dividend} - \text{Total Preferred Dividends} = 130,000 - 80,000 = 50,000 \text{ dollars}$$

Each common share, therefore, receives:

$$\text{Dividend per Common Share} = \frac{\text{Remaining for Common Shareholders}}{\text{Number of Common Shares}} = \frac{50,000}{50,000} = 1 \text{ dollar}$$

In summary, preferred shareholders receive $8 per share, totaling $80,000, while common shareholders receive $1 per share, totaling $50,000. This structure highlights the preference of preferred stockholders in dividend distribution, ensuring they are paid before any dividends are allocated to common stockholders.

In scenarios where the total dividend is less than $80,000, all available funds would go to the preferred shareholders. Conversely, if the total dividend exceeds $80,000, the preferred shareholders would still receive their full amount, with any excess distributed to common shareholders. For example, if the total dividend were $1,000,000, preferred shareholders would receive $80,000, and the remaining $920,000 would go to common shareholders.