Chapter 11: Preferred Stock

Characteristics and Dividend Distribution for Common and Preferred Stock 1. Characteristics of Preferred Stock • • • Special Rights: Preferred stock has certain advantages over common stock, including priority in receiving dividends and in claims on assets during liquidation. Voting Rights: Often, preferred stockholders do not have voting rights unless specified in the corporate charter. Dividend Priority: Preferred stockholders are paid dividends before common stockholders. However, preferred dividends are paid only if declared by the board, and dividends are not guaranteed. 2. Cumulative vs. Noncumulative Preferred Stock • • Cumulative Preferred Stock: o Right to Dividends in Arrears: If a dividend is not declared in a given period, cumulative preferred stockholders retain the right to unpaid dividends from prior periods, known as dividends in arrears. o Example: If cumulative preferred stock has unpaid dividends from the previous year, those dividends must be paid in the current year before common stockholders receive any dividends. Noncumulative Preferred Stock: o No Right to Past Dividends: Noncumulative preferred stockholders are entitled only to the current period’s dividend. Missed dividends from prior periods are not owed if they were not declared. 3. Example of Dividend Allocation Between Preferred and Common Stock • • • Assume a company has: o 1,000 shares of $100 par, 9% cumulative preferred stock: Potential dividend = 1,000 shares × $100 × 9% = $9,000 per year. o 4,000 shares of $50 par common stock. In Year 1, the company declares $5,000 in dividends: o Cumulative Preferred: $4,000 will be carried forward as arrears, and preferred stockholders receive the $5,000 in Year 2. o Noncumulative Preferred: No unpaid dividends are carried forward, so common stockholders may receive dividends based on current year availability. In Year 2, the company declares $42,000 in dividends: o Cumulative Preferred: $9,000 is allocated to preferred (including $4,000 arrears), leaving $33,000 for common stockholders. o Noncumulative Preferred: Only $9,000 is allocated to preferred, and the remaining $33,000 goes to common stockholders without covering Year 1's unpaid amount. 4. Reasons for Issuing Preferred Stock • • • Control Retention: Preferred stock can raise funds without diluting control, especially if issued without voting rights. Enhanced Return for Common Stockholders: Preferred stock dividends, typically fixed, can increase returns for common stockholders if the corporation’s return on assets exceeds the preferred dividend rate (financial leverage). Investor Appeal: Preferred stock may attract conservative investors who prioritize dividend stability over the potentially higher but riskier returns of common stock. 5. Journal Entry for Issuing Preferred Stock • When a corporation issues preferred stock, it records the transaction in its equity accounts similarly to common stock. For example: o If Dillon issues 50 shares of $100 par preferred stock for $6,000 cash: plaintext Debit Cash $6,000 Credit Preferred Stock $5,000 Credit Paid-In Capital in Excess of Par— Preferred Stock $1,000 6. Example of Cash Dividend Allocation • • • Assume a company has: o 80 shares of noncumulative, 5% preferred stock with $5 par value, entitled to $20 in dividends per year. o 200 shares of $1 par common stock. Dividend Distribution for Noncumulative Preferred Stock: o Year 1 (Total Dividends = $40): Preferred stockholders receive $20, common stockholders receive $20. o Year 2 (Total Dividends = $50): Preferred stockholders receive $20, common stockholders receive $30. o Year 3 (Total Dividends = $60): Preferred stockholders receive $20, common stockholders receive $40. Dividend Distribution for Cumulative Preferred Stock: o Year 1 (Total Dividends = $40): Preferred stockholders receive $20, common stockholders receive $20. o Year 2 (Total Dividends = $50): Preferred stockholders receive $20, common stockholders receive $30. o Year 3 (Total Dividends = $60): Preferred stockholders receive $20, common stockholders receive $40. Key Takeaways • • • Preferred Stockholders: Typically receive dividends before common stockholders but do not have voting rights. Cumulative preferred stockholders are entitled to past unpaid dividends. Common Stockholders: Receive dividends only after preferred stockholders are paid and have voting rights to influence corporate decisions. Dividend Allocation: Varies depending on whether preferred stock is cumulative or noncumulative, impacting how dividends are distributed among shareholders.