8.3.1 Preferred Shareholder’s Claim To Assets

The Preferred Shareholder’s Claim to Assets

Preferred shareholders are usually entitled to a fixed dividend payment, subject to the discretion of the board of directors. Because of this regular income stream, most preferreds are considered a type of fixed-income security.

However, preferred shareholders are not in the same category as creditors holding other fixed-income securities, such as bonds and debentures. As part owners of a company, along with common shareholders, preferred shareholders rank behind creditors in their claim to assets. Preferreds do, however, have priority status over common shares in the event of bankruptcy or dissolution of the company.

Some companies issue more than one class of preferred stock. When this occurs, each class is identified separately.

If the rank of various outstanding preferred share issues is equal, as to asset and dividend entitlement, the shares are described as ranking pari passu.

Did You Know?

Some examples refer to preference shares. These shares are generally the same as preferreds but can rank ahead of the different classes of preferreds that a company has outstanding.

Example: Pari Passu

ABC Corporation Limited has three preference share issues outstanding: a $2.50 Series Class A Preference; a $2.60 Series Class A Preference; and a $2.70 Series Class B Preference. The three issues rank equally as to asset and dividend entitlement and are thus ranked pari passu.

Preference as to Assets

As mentioned, preferred shareholders rank ahead of common shareholders but behind creditors and debenture holders in their claim to assets. The preferred share investor is therefore better protected than the common shareholders, but ranks below the claims of creditors and debenture holders.

A preference as to assets clause stating this priority is found in most preferred share issues. Because preferred shareholders usually have no claim on earnings beyond the fixed dividend, it is fair for their position to be buttressed by a prior claim on assets, ahead of the common shares. The common shareholder must be content with anything that is left after all creditor, debenture holder, and preferred shareholder claims have been met.

Mathematical Formula for Dividend Calculation

The fixed dividend for preferred shares can be calculated as follows:

$$ \text{Annual Dividend} = \text{Par Value} \times \text{Dividend Rate} $$

Example: Calculating Preferred Share Dividends

DEF Limited’s $50 par value 5.6% First Preferred Series U shares, currently trading at $53.75 per share, pay a fixed annual dividend of $2.80 per share ($50 par value × 5.6% = $2.80 annual dividend).

Preference as to Dividends

Preferreds are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents.

Dividends are paid from earnings, either current or past. However, unlike interest on a debt security, dividends are not obligatory; they are payable only if declared by the board of directors. If the board omits the payment of a preferred dividend, there is very little the preferred shareholders can do about it. However, the charters of some companies provide that no dividends are paid to common shareholders until preferred shareholders have received full payment of dividends to which they are entitled.

Directors have the right to defer the declaration of preferred dividends indefinitely. In practice, however, dividends are paid if they are justified by earnings. Failure to declare an anticipated preferred dividend has unfavorable repercussions. Besides weakening investor confidence, the general credit, and future borrowing power of the company suffer.

Because most preferreds can be considered fixed-income securities, they do not offer the same potential for capital appreciation that common shares provide for investors. Should interest rates decline, the preferreds would increase in price, much like a bond. However, good corporate earnings would have no effect on the dividend rate or equity allocation. Therefore, the dividend rate is of prime importance to the preferred shareholder.

Key Takeaways

• Preferred shareholders have a fixed income stream and rank ahead of common shareholders but behind creditors in the event of liquidation or bankruptcy.
• Different classes of preferred shares exist, and they can rank pari passu if they hold the same status in terms of asset and dividend entitlement.
• Preferred dividends are not obligatory and are declared at the discretion of the board of directors; however, failing to pay them could harm investor confidence and the company’s creditworthiness.
• Preferred shares offer limited potential for capital appreciation but provide a steady income, which makes them similar to fixed-income securities like bonds.

Frequently Asked Questions (FAQs)

Q1: What does pari passu mean in the context of preferred shares?

A1: Pari passu is a Latin term meaning “equal footing.” In the context of preferred shares, it means that multiple classes of preferred shares have equal rank and priority in terms of asset and dividend entitlement.

Q2: How are preferred dividends different from interest payments on bonds?

A2: Unlike interest payments on bonds, preferred dividends are not mandatory. They are paid at the discretion of the board of directors and only if declared. However, not paying dividends can have negative effects on the company’s reputation and credit standing.

Q3: Why don’t preferred shares offer significant capital appreciation?

A3: Preferred shares are similar to fixed-income securities; they are valued primarily for their steady dividend income rather than their potential for capital growth. As such, their price is more sensitive to interest rate changes than to corporate earnings.

Glossary

• Fixed-Income Security: A type of investment that pays regular income, such as bonds or preferred shares.
• Pari Passu: A term that means on equal footing, used to describe investments that have equal claim to payments or assets.
• Dividend: A sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
• Par Value: The face value of a bond or share; the amount paid out at maturity for bonds or initial amount paid for shares.