Questions and Answers on Preferred Stocks Paper Example

Question 1: What are the preferred stocks?

A preferred stock can be defined as a class of ownership in a company. The stock has a higher claim on the company's assets and earnings compared to the common stock (Brigham & Ehrhardt, 2017). There are two basic types of stocks that a company can have and that are available to investors, preferred shares and common shares. The common stocks represent a percentage of the shareholding in the company. Preferred stocks are hybrid investment vehicles that pay interest on a regular basis, such as bonds, but also represent shareholding in the company, as an action. Both types of shares have different advantages and disadvantages for investors.

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Question 2: You have stated that both stocks have benefits and disadvantages, what are the benefits of preferred stock?

First, preferred stocks have a guaranteed dividend. Unlike common stock, preferred stocks pay a guaranteed dividend. A dividend is a cash payment that the company makes to shareholders on a regular basis, similar to the payment of interest accrued by bond investors (Damodaran, 2012). This can be an important feature if an investor requires an income from his/her investments in the form of dividends that are paid each quarter.

Secondly, preferred shareholders are paid first. Preferred shares earn their name because shareholders receive preferential treatment when a company declares bankruptcy. If an investor owns preferred stock, they will be paid with the funds from the sale of the bankrupt company before the common shareholders receive their payment. In a bankruptcy, a company may not have money to pay the common shareholders after the preferred shareholders are paid.

The rights of the preferred stocks are subordinated to those of the obligations, but priority to those of the common stocks. That is, dividend payments and rights over the assets of the company in case of default or bankruptcy of the preferred shareholders are secondary to those of the creditors (Dow, 2007). However, preferred shareholders take priority in both the payment of dividends and the liquidation value of the assets of the company in case of default or bankruptcy before the common shareholders.

Question 3: What are the disadvantages of preferred stock?

First, common stocks have higher returns. Over time, the common stock provides the highest rate of return among all financial securities, including preferred stock, bonds, and other investment instruments. Common stocks have consistently earned an average of at least 10 percent per year, compared to 7.4 percent earned by preferred shareholders, according to USA Today (Burke, 2015). Owning preferred stock instead of having common stocks can be a disadvantage if one is a long-term investor seeking to maximize his/her investment returns.

Secondly, owners of preferred stock do not obtain a vote. As a shareholder of common stock, one has a right to vote at the company's shareholders meetings. Companies operate much like a representative democracy (Burke, 2015). The board members of the company are elected by the common shareholders. Each common action, in general, receives one vote. However, those who have preferred stock do not have the right to vote. Typically, the holders of these stock can vote only during extraordinary meetings, and not during ordinary ones.

Another disadvantage of the preferred stocks has to do with how unattractive these instruments are for investors due to their characteristics. Consequently, many recent emissions include "sweeteners". That is, to make preferred shares more attractive, issuers include voting rights, payment of cumulative dividends, among others. Moreover, to make them more attractive, some recent issues of preferred shares link the preferred dividend with a bond index of the United States Treasury, with upper and lower limits on rates. These instruments are called preferred shares with an adjustable rate.

Question 4: In conclusion, should one invest in common or preferred stock?

In light of what I have said about the difference between common and privileged, it can be said that by investing in common shares, one can make a profit from the increase in the price of the share and from the presence of a possible dividend. As long as they are there. If the company makes losses or becomes bankrupt, holders of common stock will suffer huge losses. Certainly, the fluctuation band of the price of ordinary shares is more limited if the investor bets on the big stocks of the main stock exchange index (Dow, 2007). But this consideration, as shown by the financial crisis of recent years, has revealed that it belongs to a prehistoric vision of finance. For their part, preference shares are exposed to lower volatility and therefore are less risky. Moreover, the almost certain presence of the dividend is another point in their favor. On the other hand, the privileged cannot guarantee that typical appreciation of ordinary shares. In so doing, as part of an investment strategy that focuses on share ownership, the focus is on common stock if one is looking for profits that may be more substantial but suffer a greater risk of loss, while one buys preferred stock if he/she prefers the tranquility of a less volatile but also less profitable investment.

References

Brigham, E. F., & Ehrhardt, M. C. (2017). Financial management: Theory and practice. Chapter 20, pp. 820-824. Boston (MA): Cengage Learning.

Burke, J (2015). "Preferred Stocks Are a Gamble for Retirement Investors." Wall Street Sector Selector, http://www.wallstreetsectorselector.com/investment-articles/editors-desk/2015/03/preferred-stocks-are-a-gamble-for-retirement-investors/.

Damodaran, A (2012). Investment Valuation, New York: John Wiley & Sons.

Dow, C (2007). "Preferred Stocks." Dow Publishing Company, http://www.dows.com/Publications/Preferred_Stocks.pdf.