Reading: Lesson 5 - Preferred Stock

7.5.A - Preferred Stock

1. Preferred Stock

1. Preferred stock is a hybrid—it’s similar to bonds in some respects and to common stock in others. Like bonds, preferred stock has a par value, and a fixed amount of dividends must be paid on it before dividends can be paid on the common stock. However, if the preferred dividend is not earned, the directors can omit (or “pass”) it without throwing the company into bankruptcy. So, although preferred stock has a fixed payment like bonds, a failure to make this payment will not lead to bankruptcy. The dividends on preferred stock are fixed, and if they are scheduled to go on forever, the issue is a perpetuity whose value is found as follows: 
   

   
   

2. Vps is the value of the preferred stock, Dps is the preferred dividend, and rps is the required rate of return. Notice that the Equation below is just a special case of the constant dividend growth model for which growth is zero. MicroDrive has preferred stock outstanding that pays a dividend of $8 per year. If the required rate of return on this preferred stock is 8%, then its value is $100: 
   

   
   

3. If we know the current price of a preferred stock and its dividend, we can transpose terms and solve for the expected rate of return as follows: 
   

   
   

4. Some preferred stock has a stated maturity, say, 50 years. If a firm’s preferred stock matures in 50 years, pays a $8 annual dividend, has a par value of $100, and has a required return of 6%, then we can find its price using a financial calculator: Enter N = 50, I/YR = 6, PMT = 8, and FV = 100. Then press PV to find the price, Vps = $131.52. If you know the price of a share of preferred stock, you can solve for I/YR to ^ find the expected rate of return, rps. Most preferred stock pays dividends quarterly. This is true for MicroDrive, so we could find the effective rate of return on its preferred stock as follows: 
   

   

5. If an investor wanted to compare the returns on MicroDrive’s bonds and its preferred stock, it would be best to convert the nominal rates on each security to effective rates and then compare these “equivalent annual rates.”