5 Preferred StockHybrid security -- Characteristics of both common stock and bondsCommon stock characteristics:No fixed maturity dateFailure to pay dividends does not bring on bankruptcyDividends are not deductibleBond Characteristics:Dividends are limited or fixed either as a percentage of par value or specific dollar amount
6 Features of Preferred Stock Multiple ClassesIf a company desires, it can issue more than one series or class of preferred stock, and each class can have different characteristicsClaim on AssetsPreferred stock has priority over common stock with regard to claims on assets in the case of bankruptcy. A preferred stock claim is honored after bonds and before common stock.The firm must pay preferred stock dividends before it pays common stock dividends
7 Cumulative Dividends: Cumulative Dividends: Requires all past, unpaid preferred stock dividends be paid before any common stock dividends are declared.Protective Provisions: Allow for voting rights in the event of nonpayment of dividends or they can restrict the payment of common stock dividends if sinking fund payments are not met or if the firm is in financial difficulty.Convertibility: At the discretion of the holder, the stock can be converted into a predetermined number of shares of common stock. About one-third of all preferred stock issued has a convertibility feature.
8 Retirement Features--Preferred Stock Callable Preferred Most preferred stock has some type of call provision—entitles a company to repurchase its preferred stock (or bonds) from their holders at stated prices over a given time period.Sinking Fund Provision Requires the firm periodically to set side an amount of money for the retirement of its preferred stock
9 Valuing Preferred Stock The value of a preferred stock is the present value of all future dividends.Calculate the value of preferred stock:Annual dividend/required rate of return
10 Common Stock Certificate that indicates ownership in a corporation Common stockholders are the true owners of the firm
11 Features or Characteristics of Common Stock Claim on Assets The common shareholders have the right to the residual income after bondholders (and other creditors) and preferred stockholders have been paid.Voting Rights The common shareholders are entitled to elect the board of directors and are in general the only security holders given a vote.Preemptive Rights Entitles the common shareholder to maintain a proportionate share of ownership in the firm.Limited Liability The common shareholder’s liability in the case of bankruptcy is limited to the amount of their investment.
12 VotingMajority Voting Each share of stock allows the shareholder one vote, and each position on the board is voted on separately.Cumulative Voting Each share of stock allows the stockholder a number of votes equal to the number of directors being elected. The shareholder may cast all votes for a single candidate or split them among the various candidates.
13 Valuing Common Stock Two Methods: Present Value of all future dividendsFree Cash flow method
14 Valuation of Common Stock Dividend Valuation Method:Common Stock Value =dividend in year 1/ (required rate of return – growth rate)Free Cash Flow Method:Shareholder value = Firm Value – debt / number of shares outstandingWhere firm value is the present value of free cash flows
15 Expected Rate of Return The expected rate of return on a security is the required rate of return of investors who are willing to pay the market price for the security.Preferred Stock Expected Return:Annual dividend/market priceCommon Stock Expected Return(Dividend in year 1 / market price) + dividend growth rate