Advantages and Disadvantages of Preferred Stock

Advantages of preferred stock

Preferred stock are advantageous from the viewpoint of the issuer and the investors.

Form the company’s viewpoint:

Risk less leverage advantage: Preferred shares increase financial leverage because, first of all, the preferred dividend is a fixed obligation and unlike debentures there is no default ever if the dividend is not paid. That means, non-payment of dividend doesn’t force the company into insolvency. Thus, there is an increased risk less financial leverage.

Repayment anxiety and dividend postponability: The maturity period of a perpetual preferred stock is not specified. Thus, there is no obligation to call the preferred stock within a specified time. This is a permanent source of financing, which will not result in liquidation ever if the dividend and par value/stock value is not paid for a longer period of time. The firm has no repaying anxiety and can easily postpone the payment of dividend.

Fixed dividend: The preferred dividends are restricted to the stated amount. Thus, preferred shareholders do not participate in excess profit as the ordinary shareholders do.

Control: preference shareholders do not have a voting right unless the dividend arrears exit. They do not have a voice in the management of the company, therefore the control of ordinary shareholders remains secure.

Flexibility: preferred stocks are free of maturity period. Besides, the dividend can be postponed if earning is insufficient or uncertain. Thus, this is a flexible source of financing.

Ease in expansion: It facilitates those firms that want to expand their business because preferred stock secures the interest of the shareholders as they have a prior claim on the earning and assets. Hence, the company can raise a greater fund by issuing preferred stocks than by issuing common stock

Participation in earning: Ordinary shareholders have equal participation in the earnings made through additional issuance of ordinary shares. But, such participation is not there in case of preferred stock. Their claim is restricted to a limited amount per share. Hence, preferred stocks are in flavor of the owners.

Disadvantage of preferred stock

Cost: It is costly because, generally, dividend rate on such shares is higher than interest rate payable on debentures. Similarly, preference dividend is paid out of earning after interest and tax. The higher the tax rate, the higher the cost of preference shares and it will be inefficient to raise fund through preferred stock issuance. In other words, it is costlier than debentures because it is not tax deductible.

Difficult to sell the stocks: Investors may not like to invest on preferred stocks because they go only a fixed amount of dividend even though unstable they may not get preferred dividend as such dividend even though the firms earning is too high. Besides, if the earning of the firm is low or unstable they may not get preferred dividend as such dividend is not an obligation to the firm. Thus, it is difficult to sell the stocks.

Seniority claim: The preferred stockholders have a prior claim over the earning and assets of the company. This adversely affects the claim of ordinary shareholders. Their claim will, however, be lower than that of preferred stockholders.

Commitment to pay dividend: Common stockholders cannot get dividend unless preferred dividend is paid. Thus, it becomes a sort of obligation to pay preferred dividend.