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Preferred Stock

Usually when investors talk about equity or stock, they are referring to common stock. But Heinz has also issued $200,000 of preferred stock, and this too is part of the company`s equity. The sum of Heinz`s common equity and preferred stock is known as its net worth.

For most companies preferred stock is much less important than common stock. However, it can be a useful method of financing in mergers and certain other special situations. Like debt, preferred stock promises a series of fixed payments to the investor and with relatively rare exceptions preferred dividends are paid in full and on time. evertheless, preferred stock is legally an equity security. This is because payment of a preferred dividend is almost invariably within the discretion of the directors. The only obligation is that no dividends can be paid on the common stock until the preferred dividend has been paid.2 If the company goes out of business, the preferred stockholders get in the queue after the debtholders but before the common stockholders.

Preferred stock rarely confers full voting privileges. This is an advantage to firms that want to raise new money without sharing control of the firm with the new shareholders. However, if there is any matter that affects their place in the queue, preferred stockholders usually get to vote on it. Most issues also provide the holder with some voting power if the preferred dividend is skipped. Companies cannot deduct preferred dividends when they calculate taxable income.

Like common stock dividends, preferred dividends are paid from after-tax income. For most industrial firms this is a serious deterrent to issuing preferred. However, regulated public utilities can take tax payments into account when they negotiate with regulators the rates they charge customers. So they can effectively pass the tax disadvantage of preferred on to the consumer. A large fraction of the dollar value of new offerings of ordinary preferred stock consists of issues by utilities.

Preferred stock does have one tax advantage. If one corporation buys another`s stock, only 30 percent of the dividends it receives is taxed. This rule applies to dividends on both common and preferred stock, but it is most important for preferred, for which returns are dominated by dividends rather than capital gains.

Suppose that your firm has surplus cash to invest. If it buys a bond, the interest will be taxed at the company`s tax rate of 35 percent. If it buys a preferred share, it owns an asset like a bond (the preferred dividends can be viewed as ¬interest ­), but the effective tax rate is only 30 percent of 35 percent, .30 ГЧ .35 = .105, or 10.5 percent. It is no surprise that most preferred shares are held by corporations.

If you invest your firm`s spare cash in a preferred stock, you will want to make sure that when it is time to sell the stock, it won`t have plummeted in value. One problem with garden-variety preferred stock that pays a fixed dividend is that the preferreds` market prices go up and down as interest rates change (because present values fall when rates rise). So one ingenious banker thought up a wrinkle: Why not link the dividend on the preferred stock to interest rates so that it goes up when interest rates rise and vice versa? The result is known as floating-rate preferred. If you own floating-rate preferred, you know that any change in interest rates will be counterbalanced by a change in the dividend payment, so the value of your investment is protected.

Corporate Debt

When they borrow money, companies promise to make regular interest payments and to repay the principal (that is, the original amount borrowed).

However, corporations have limited liability. By this we mean that the promise to repay the debt is not always kept. If the company gets into deep water, the company has the right to default on the debt and to hand over the company`s assets to the lenders.

Clearly it will choose bankruptcy only if the value of the assets is less than the amount of the debt. In practice, when companies go bankrupt, this handover of assets is far from straightforward. For example, when the furniture company Wickes went into bankruptcy, there were 250,000 creditors all jostling for a better place in the queue. Sorting

out these problems is left to the bankruptcy court.

Because lenders are not regarded as owners of the firm, they don`t normally have any voting power. Also, the ompany`s payments of interest are regarded as a cost and are therefore deducted from taxable income. Thus interest is paid out of before-tax income, whereas dividends on common and preferred stock are paid out of after-tax income. This means that the government provides a tax subsidy on the use of debt, which it does not provide on stock.

FLOATING-RATE PREFERRED Preferred stock paying dividends that vary with short-term interest rates.

PREFERRED STOCK Stock that takes priority over common stock in regard to dividends.

NET WORTH Book value of common stockholders` equity plus preferred stock.