Principles of Managerial Finance

CHAPTER 7 Stock Valuation 313

no-par preferred stock
Preferred stock with no stated
face value but with a stated
annual dollar dividend.

par-value preferred stock
Preferred stock with a stated
face value that is used with the
specified dividend percentage to
determine the annual dollar
dividend.

cumulative preferred stock
Preferred stock for which all
passed (unpaid) dividends in
arrears, along with the current
dividend, must be paid before
dividends can be paid to common
stockholders.

Preferred Stock

Preferred stockgives its holders certain privileges that make them senior to com-

mon stockholders. Preferred stockholders are promised a fixed periodic dividend,

which is stated either as a percentage or as a dollar amount. How the dividend is

specified depends on whether the preferred stock has a par value,which, as in

common stock, is a relatively useless stated value established for legal purposes.

Par-value preferred stockhas a stated face value, and its annual dividend is speci-

fied as a percentage of this value. No-par preferred stockhas no stated face value,

but its annual dividend is stated in dollars. Preferred stock is most often issued by

public utilities, by acquiring firms in merger transactions, and by firms that are

experiencing losses and need additional financing.

Basic Rights of Preferred Stockholders

The basic rights of preferred stockholders are somewhat more favorable than the

rights of common stockholders. Preferred stock is often considered quasi-debt

because, much like interest on debt, it specifies a fixed periodic payment (divi-

dend). Of course, as ownership, preferred stock is unlike debt in that it has no

maturity date. Because they have a fixed claim on the firm’s income that takes

precedence over the claim of common stockholders, preferred stockholders are

exposed to less risk. They are consequently not normally given a voting right.

Preferred stockholders have preference over common stockholders in the dis-

tribution of earnings.If the stated preferred stock dividend is “passed” (not paid)

by the board of directors, the payment of dividends to common stockholders is

prohibited. It is this preference in dividend distribution that makes common

stockholders the true risk takers.

Preferred stockholders are also usually givenpreference over common stock-

holders in the liquidation of assetsin a legally bankrupt firm, although they must

“stand in line” behind creditors. The amount of the claim of preferred stockhold-

ers in liquidation is normally equal to the par or stated value of the preferred stock.

Features of Preferred Stock

A number of features are generally included as part of a preferred stock issue.

These features, along with the stock’s par value, the amount of dividend pay-

ments, the dividend payment dates, and any restrictive covenants, are specified in

an agreement similar to a bond indenture.

Restrictive Covenants The restrictive covenants in a preferred stock issue

are aimed at ensuring the firm’s continued existence and regular payment of the

dividend. These covenants include provisions about passing dividends, the sale of

senior securities, mergers, sales of assets, minimum liquidity requirements, and

repurchases of common stock. The violation of preferred stock covenants usually

permits preferred stockholders either to obtain representation on the firm’s

board of directors or to force the retirement of their stock at or above its par or

stated value.

Cumulation Most preferred stock is cumulativewith respect to any divi-

dends passed. That is, all dividends in arrears, along with the current dividend,