Types of Preferred Stock: Comprehensive Guide for Series 7 Exam

3.2.1 Types of Preferred Stock

Preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares generally have a dividend that must be paid out before dividends to common shareholders and the shares usually do not have voting rights. Understanding the different types of preferred stock is crucial for the Series 7 Exam, as each type serves distinct investment objectives and has unique characteristics.

Cumulative Preferred Stock

Cumulative Preferred Stock is a type of preferred stock where dividends accumulate if they are not paid. This means that if a company is unable to pay dividends in any given year, the unpaid dividends accumulate and must be paid out before any dividends can be distributed to common shareholders. This feature provides an additional layer of security to investors, making cumulative preferred stock a more attractive option for risk-averse investors.

Example of Cumulative Preferred Stock

Imagine a company that issues cumulative preferred stock with a $5 annual dividend. Due to financial difficulties, the company is unable to pay dividends for two consecutive years. In the third year, before any dividends can be paid to common shareholders, the company must pay $15 per share to cumulative preferred stockholders ($5 for each of the three years).

Investment Objectives

• Income Stability: Cumulative preferred stock is ideal for investors seeking stable income, as it ensures that missed dividend payments will eventually be made.
• Lower Risk: The cumulative feature reduces the risk of income loss, making it suitable for conservative investors.

Convertible Preferred Stock

Convertible Preferred Stock gives holders the option to convert their preferred shares into a predetermined number of common shares, usually at a specific conversion price. This type of preferred stock provides the potential for capital appreciation if the company’s common stock performs well.

Example of Convertible Preferred Stock

Consider a convertible preferred stock with a conversion ratio of 5:1, meaning each preferred share can be converted into five common shares. If the market price of the common stock rises significantly, converting the preferred shares can result in substantial gains for the investor.

Investment Objectives

• Growth Potential: Convertible preferred stock appeals to investors who want the income stability of preferred dividends but also want the potential for capital appreciation.
• Flexibility: Investors have the option to convert their shares if the common stock’s market performance is favorable.

Participating Preferred Stock

Participating Preferred Stock allows shareholders to receive additional dividends beyond the fixed rate if the company achieves certain financial goals, such as reaching a specific profit level. In liquidation, participating preferred shareholders may also receive a share of the residual value after all debts and other obligations are paid.

Example of Participating Preferred Stock

A company issues participating preferred stock with a 6% annual dividend. If the company achieves a profit target, shareholders may receive an additional dividend that increases their total yield to 8%. In the event of liquidation, after receiving their par value, they may also share in any remaining assets.

Investment Objectives

• Enhanced Income: Participating preferred stock is suitable for investors seeking higher income potential, especially if the company performs well.
• Profit Sharing: Investors benefit from the company’s success through additional dividends or liquidation proceeds.

Callable Preferred Stock

Callable Preferred Stock gives the issuing company the right to repurchase the shares at a predetermined price after a specified date. This feature allows the company to refinance its equity if it can issue new shares at a lower dividend rate.

Example of Callable Preferred Stock

A company issues callable preferred stock with a 5% dividend and a call price of $25 per share. If interest rates decline, the company might call the stock and issue new preferred shares at a lower dividend rate, reducing its cost of capital.

Investment Objectives

• Higher Initial Yield: Callable preferred stock often offers a higher initial yield to compensate for the call risk.
• Interest Rate Sensitivity: Investors who anticipate stable or rising interest rates might favor callable preferred stock, as the likelihood of being called decreases.

Comparison of Types of Preferred Stock

To better understand the differences between these types of preferred stock, consider the following table:

Calculation Exercises

To solidify your understanding of preferred stock, let’s work through some calculation exercises.

Exercise 1: Cumulative Dividends

A company issues cumulative preferred stock with a $4 annual dividend. Due to financial constraints, it skips dividends for two years. In the third year, it resumes dividend payments. Calculate the total dividend payment required for cumulative preferred shareholders in the third year.

Solution:

• Missed dividends for two years: $4 x 2 = $8
• Current year dividend: $4
• Total dividend payment: $8 + $4 = $12

Exercise 2: Conversion Value

An investor holds convertible preferred stock with a conversion ratio of 4:1. The current market price of the common stock is $30. Calculate the conversion value of one preferred share.

Solution:

• Conversion value = Conversion ratio x Market price of common stock
• Conversion value = 4 x $30 = $120

Real-World Applications and Regulatory Scenarios

Understanding the real-world applications of preferred stock is crucial for the Series 7 Exam and your future career in the securities industry. For instance, companies may issue cumulative preferred stock during times of financial uncertainty to attract investors looking for income security. Convertible preferred stock is often used by companies in growth phases to provide investors with the potential for capital appreciation while maintaining a fixed income component.

Regulatory considerations also play a role in preferred stock issuance. The Securities Act of 1933 and the Securities Exchange Act of 1934 govern the issuance and trading of preferred stocks, ensuring transparency and protecting investors. Compliance with these regulations is essential for securities professionals.

Best Practices and Common Pitfalls

• Best Practices:

  • Assess the company’s financial health before investing in cumulative preferred stock to ensure dividend payments are likely.
  • Evaluate the conversion terms and market conditions when considering convertible preferred stock.
  • Consider the company’s profitability and growth potential when investing in participating preferred stock.
  • Be aware of interest rate trends and call provisions when investing in callable preferred stock.

• Common Pitfalls:

  • Overlooking the impact of missed dividends on cumulative preferred stock.
  • Ignoring the conversion ratio and market price when evaluating convertible preferred stock.
  • Failing to account for additional dividend conditions in participating preferred stock.
  • Underestimating the risk of early redemption with callable preferred stock.

Conclusion

Understanding the different types of preferred stock is essential for passing the Series 7 Exam and succeeding in the securities industry. Each type of preferred stock serves unique investment objectives and comes with its own set of risks and rewards. By mastering these concepts, you can confidently advise clients and make informed investment decisions.

Series 7 Exam Practice Questions: Types of Preferred Stock

In this section

• Cumulative Preferred Stock: Understanding Accumulated Dividends and Their Impact
  Explore the world of Cumulative Preferred Stock, a key component of equity securities, and understand how accumulated dividends affect investment strategies and corporate financial practices.
• Convertible Preferred Stock: Understanding Conversion Ratios and Parity Prices
  Master Convertible Preferred Stock for the Series 7 Exam. Learn about conversion advantages, calculate conversion ratios and parity prices, and prepare with practice problems.
• Participating Preferred Stock: Understanding Additional Dividends
  Explore the intricacies of Participating Preferred Stock, including how shareholders receive additional dividends beyond the fixed rate. Learn through detailed examples and calculations.
• Callable Preferred Stock: Understanding Features, Risks, and Opportunities
  Dive into callable preferred stock, exploring issuer rights, yield impacts, and risk considerations. Gain insights from real-world case studies to master this key Series 7 Exam topic.