Preferred stock has two main characteristics that distinguish

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Question: Preferred stock is said to be a hybrid of common…

Preferred stock is said to be a hybrid of common stock and bonds. Explain fully. Describe the cash flows associated with preferred and their valuation.

Answer)

Preferred stock has two main characteristics that distinguish it from common stock. First, if a company liquidates, any money that’s left over for shareholders goes first to holders of preferred stock up to a set amount, and only if there’s any remaining after that do common shareholders get anything. Second, preferred shareholders have preferential treatment with dividends, and if the issuing company doesn’t pay the full amount of dividends set forth in the prospectus, then it can’t pay common shareholders any dividend. Preferred stock is referred to a hybrid security because it has similarities to both common stock and bonds, they have no “fixed maturity date, if dividends aren’t paid by the firm, “it does not bring on bankruptcy, and dividends are not tax deductible. There is a similarity with bonds, in that their dividends have a fixed amount. Preferred stock shares elements of bonds and common stocks, and as such, many consider it to be a hybrid security. The par value is equivalent to the face value of a bond, and the dividend rate specified in the prospectus matches up to the coupon rate of the bond.

Lasher, W. R. (2013). Practical Financial Management, 7th Ed, Cengage Publishing