What are Preferred Dividends?

//What are Preferred Dividends?
What are Preferred Dividends? 2017-10-09T05:52:09+00:00

Definition: Preferred Dividends are cash distributions that are paid to the owners of a company’s preferred shares. In other words, this is the amount of money preferred shareholders receive from the company’s retained earnings each year.

What Does Preferred Dividends Mean?

Many large corporations have multiple classes of stock. The most common are common shares and preferred shares. Although preferred shareholders don’t have voting rights like common shareholders do, there are several advantages to owning preferred stock.

Preferred shareholders enjoy guaranteed payments at higher dividend rates than common shareholders. This means that preferred shareholders can expect dividends on a regular basis. If the board does not declare a payment to shareholders, the guaranteed payments for this period are put into arrears. This is kind of like a liability account that the company puts on its books notifying that it owes money to the preferred shareholders. Once a dividend is paid, the preferred shareholders must be paid out any amount in arrears before their current payment is made.

If the company doesn’t issue dividends high enough to cover the amount in arrears and the current preferred guarantee, the common shareholders will not receive any.

In general, preferred dividends are for investors that are looking for less risk in an investment, while still providing the benefits that traditional shares and traditional debt do.

Let’s look at an example.

Example

Julia is the CEO of Target, a large, public retailer that sells ownership in its company through the stock market. She has a large expansion planned, and in order to do that she needs to raise $10,000,000. In order to raise that money, she has a few options: she can issue more traditional stock, or she can issue preferred stock that gives investors preferred dividends. This is an important issue, as the cost of raising money for a company is vital to an efficient and profitable business.

She talks to some of her directors and board members, and together they weight the benefits and drawbacks of each option. For traditional stock, they would be giving up a piece of their company through voting rights, as well as creating a more expensive cost of capital for the firm due to that ownership. However, if they issue preferred stock, they would not give up ownership, their cost of capital would be lower compared to the other option, and the shareholder receives fixed, periodic payments of $100 per year. Together, they decide to issue $10,000,000 of preferred stock.

Since the company’s stock is trading at $40, they will issue 250,000 shares of preferred stock. In the future, they will need to pay out $25,000,000 per year to preferred shareholders, which will reduce retained earnings, but they believe the expansion will make up for the expenditure.

The following year the company issues a dividend of $30M. $25,000,000 will go to the preferred shareholders while the remaining $5,000,000 will be split between the common shareholders.

Now let’s fast forward a few years and assume that $40M has accumulated in arrears. If the company issues a $50M dividend, the first $40M will go to preferred shareholders to pay off their arrears. The remaining $10M will also go to preferred shareholders to pay a portion of their current amount due. At the end of the year, $15M will accumulate in arrears for the unpaid current portion and common shareholders will receive nothing.

Preferred dividends are an extremely attractive option to the investors, who purchase all 250,000 shares quickly. They are provided with a guaranteed dividend of $100 per year, and have a higher claim to the company in event of a bankruptcy.