8.3.2 Why Companies Issue Preferred Shares
Overview
Preferred shares are a unique form of equity financing often chosen by companies under specific market and financial conditions. While dividends from preferred shares are not tax-deductible—as opposed to interest payments on debt—the benefits can sometimes outweigh these costs. This section details the reasons companies may opt to issue preferred shares over other financing methods such as debt or common shares.
Preferred Issue versus Debt Issue
When considering issuing preferred shares instead of debt, companies take into account several factors:
Flexibility: Preferred shares provide more flexibility compared to debt. Unlike debt, preferred shares usually do not demand regular interest payments and often do not have specific maturity dates. Some might have a purchase or sinking fund, but if dividends are missed, there are generally no severe immediate penalties such as asset seizure.
Dividend Discretion: A company has the ability to omit dividend payments on preferred shares without immediate drastic consequences. Dividends are typically not omitted arbitrarily; however, in scenarios where preserving working capital is vital, directors may omit dividend payments to maintain solvency.
Situations Favoring Preferred Shares over Debt
Preferred shares can be advantageous for companies for several reasons:
- Heavily Mortgaged Assets: The company may find it challenging to market new debt if its existing assets are already heavily mortgaged.
- Market Conditions: Conditions may not be ripe for new debt issues.
- High Debt-to-Equity Ratio: Adding more debt may not be prudent if the company already has significant short- and long-term debt.
- Reluctance for Legal Obligations: The directors might be wary of the legal obligations tied to paying interest and the principal associated with debt.
- Cost of Dividends: Directors may gauge that the costs associated with preferred dividends are manageable.
Preferred Shares versus Common Shares
When conditions render bonds or debentures issuance infeasible, common shares may not be attractive either due to market or business conditions. In such a case, preferred shares provide a compromise:
- Market Conditions: Unfavorable stock market conditions or inactive stock markets might make issuing common shares undesirable.
- Preservation of Equity: Issuing preferred shares does not dilute the existing equity as common shares would. This helps to maintain the proportional ownership of current shareholders.
Investors should be mindful of the liquidity aspect of preferred shares. Preferred shares can often be less liquid than common shares and corporate bonds, potentially leading to premiums on purchases or discounts on sales.
Key Takeaways
- Preferred shares offer flexibility as they do not have mandatory regular contributions like debt, nor do they significantly dilute equity like common shares.
- Companies may opt for preferred shares to strategically manage solvency, equity proportions, and flexibility in financial obligations.
- Market conditions, existing asset securities, and debt-to-equity ratios are pivotal in the decision to issue preferred shares.
Frequently Asked Questions (FAQs)
1. What are the primary benefits of issuing preferred shares for a company?
Preferred shares allow companies to raise capital without diluting equity or taking on the legal obligations associated with debt. They offer greater flexibility in managing dividends during periods of financial restraint.
2. Why might a company choose preferred shares over common shares?
Firstly, issuing preferred shares helps avoid the dilution of existing equity. Secondly, they are less affected by unfavorable stock market conditions that could make a new issue of common shares unattractive.
Glossary
- Preferred Shares: A class of ownership in a corporation with a fixed dividend that must be paid out before dividends to common shareholders.
- Debt-to-Equity Ratio: A measure of a company’s financial leverage calculated by dividing total liabilities by shareholders’ equity.
- Sinking Fund: A fund established by a company to pay off debt or a preferred stock in predetermined amounts.
Diagrams
Debt-to-Equity Ratio Impact Chart
gantt
dateFormat YYYY-MM-DD
title Preferred Shares vs. Debt Impact
section Debt Impact
High Liability :done, 2023-01-01, 30d
Regular Payments :done, 2023-02-01, 60d
Asset Security :done, 2023-04-01, 60d
section Preferred Shares Impact
High Dividends :done, 2023-01-01, 30d
Dividend Flexibility :done, 2023-02-01, 30d
No Maturity Date :done, 2023-03-01, 30d
Debt-to-Equity Ratio
$$
\text{Debt-to-Equity Ratio} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}
$$
}
📚✨ Quiz Time! ✨📚
## Why are preferred shares usually more expensive for a company compared to debt?
- [ ] Because they dilute common equity.
- [x] Because dividends paid on preferred shares are not a tax-deductible expense.
- [ ] Because they come with higher interest rates.
- [ ] Because they have shorter maturity periods.
> **Explanation:** Dividends paid on preferred shares are not tax-deductible, thus making them more expensive compared to debt, where interest is tax-deductible.
## Which advantage might justify a company issuing preferred shares despite their higher cost?
- [ ] Ensuring mandatory asset seizures.
- [x] Flexibility in dividend payments and no maturity date.
- [ ] Reducing the company's credit rating.
- [ ] Increasing short-term liabilities.
> **Explanation:** Preferred shares provide flexibility in dividend payments and typically do not have a maturity date, offering distinct advantages over issuing new debt.
## In what scenario might a company choose preferred shares over new debt?
- [ ] When the company has no existing debt.
- [ ] When the market is highly receptive to new debt issues.
- [ ] When the company's debt-to-equity ratio is low.
- [x] When existing assets are heavily mortgaged or the company already has high debt.
> **Explanation:** A company may opt for preferred shares if marketing new debt is unfeasible due to existing heavy mortgages or high debt levels.
## Why do preferred shares provide more flexibility compared to debt issues?
- [x] Directors can decide to omit dividend payments in emergencies.
- [ ] Preferred shares have a guaranteed high return.
- [ ] They always require a lower interest rate.
- [ ] They necessitate frequent restructuring.
> **Explanation:** Preferred shares offer directors the flexibility to omit dividend payments without risking solvency, unlike debt which typically requires regular interest payments.
## How can preferred shares benefit the equity component of a company?
- [x] Preferred shares increase the equity component without creating debt liabilities.
- [ ] Preferred shares decrease the company’s asset value.
- [ ] Preferred shares allow for high-frequency trading.
- [ ] Preferred shares diminish the company's share value.
> **Explanation:** Issuing preferred shares increases the equity component without the obligations of debt, avoiding the risks and liabilities associated with issuing more debt.
## Which of the following is not an advantage of issuing preferred shares compared to common shares?
- [ ] Avoiding dilution of equity.
- [x] Guaranteed high interest rates.
- [ ] Marketing as a compromise during unfavorable conditions.
- [ ] Avoiding a maturity date.
> **Explanation:** There is no guarantee of high interest rates with preferred shares. Their primary advantages include avoiding dilution, flexible marketing, and no maturity date.
## What is a reason a company might issue preferred shares instead of common shares?
- [ ] The stock market is highly active.
- [x] Market conditions for common shares are unfavorable or business prospects are uncertain.
- [ ] To increase the dilution of equity.
- [ ] To oblige a rapid increase in shareholder value.
> **Explanation:** Companies may issue preferred shares when common shares are not feasible due to poor market conditions or uncertain business prospects, offering an acceptable compromise.
## How do preferred shares affect the proportional ownership of common shareholders?
- [ ] They reduce the proportional ownership of common shareholders.
- [ ] They increase the claims on shareholder equity negatively.
- [x] They do not affect the common shareholders' equity claims or their proportional ownership.
- [ ] They create higher claims on equity beyond their par value.
> **Explanation:** Preferred shares do not affect the proportional ownership of common shareholders or their equity claims beyond their par value.
## What is a potential disadvantage of investing in preferred shares compared to common shares or corporate bonds?
- [ ] Preferred shares require consents for every trade.
- [ ] Preferred shares dilute common equity.
- [ ] Preferred shares guarantee high returns.
- [x] Preferred shares are often less liquid than common shares and many corporate bonds, possibly resulting in premiums or discounts.
> **Explanation:** Preferred shares can be less liquid, potentially requiring investors to pay a premium or sell at a discount, compared to common shares and many corporate bonds.
## What can a company avoid by issuing preferred shares instead of common shares?
- [ ] Reducing company solvency.
- [ ] Increasing short-term debt.
- [x] Avoiding dilution of equity.
- [ ] Ensuring asset seizures by shareholders.
> **Explanation:** By issuing preferred shares instead of common shares, a company can avoid the dilution of equity, maintaining the existing common shareholders’ proportional ownership.