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8.3.1 Preferred Shareholder’s Claim To Assets

Understanding the preferred shareholder's claim to assets, their priority status over common shares in the event of bankruptcy, and their entitlement to fixed dividend payments.

The Preferred Shareholder’s Claim to Assets

Preferred shareholders are usually entitled to a fixed dividend payment, subject to the discretion of the board of directors. Because of this regular income stream, most preferreds are considered a type of fixed-income security.

However, preferred shareholders are not in the same category as creditors holding other fixed-income securities, such as bonds and debentures. As part owners of a company, along with common shareholders, preferred shareholders rank behind creditors in their claim to assets. Preferreds do, however, have priority status over common shares in the event of bankruptcy or dissolution of the company.

Some companies issue more than one class of preferred stock. When this occurs, each class is identified separately.

If the rank of various outstanding preferred share issues is equal, as to asset and dividend entitlement, the shares are described as ranking pari passu.

Did You Know?

Some examples refer to preference shares. These shares are generally the same as preferreds but can rank ahead of the different classes of preferreds that a company has outstanding.

Example: Pari Passu

ABC Corporation Limited has three preference share issues outstanding: a $2.50 Series Class A Preference; a $2.60 Series Class A Preference; and a $2.70 Series Class B Preference. The three issues rank equally as to asset and dividend entitlement and are thus ranked pari passu.

Preference as to Assets

As mentioned, preferred shareholders rank ahead of common shareholders but behind creditors and debenture holders in their claim to assets. The preferred share investor is therefore better protected than the common shareholders, but ranks below the claims of creditors and debenture holders.

A preference as to assets clause stating this priority is found in most preferred share issues. Because preferred shareholders usually have no claim on earnings beyond the fixed dividend, it is fair for their position to be buttressed by a prior claim on assets, ahead of the common shares. The common shareholder must be content with anything that is left after all creditor, debenture holder, and preferred shareholder claims have been met.

Mathematical Formula for Dividend Calculation

The fixed dividend for preferred shares can be calculated as follows:

$$ \text{Annual Dividend} = \text{Par Value} \times \text{Dividend Rate} $$

Example: Calculating Preferred Share Dividends

DEF Limited’s $50 par value 5.6% First Preferred Series U shares, currently trading at $53.75 per share, pay a fixed annual dividend of $2.80 per share ($50 par value × 5.6% = $2.80 annual dividend).

Preference as to Dividends

Preferreds are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents.

Dividends are paid from earnings, either current or past. However, unlike interest on a debt security, dividends are not obligatory; they are payable only if declared by the board of directors. If the board omits the payment of a preferred dividend, there is very little the preferred shareholders can do about it. However, the charters of some companies provide that no dividends are paid to common shareholders until preferred shareholders have received full payment of dividends to which they are entitled.

Directors have the right to defer the declaration of preferred dividends indefinitely. In practice, however, dividends are paid if they are justified by earnings. Failure to declare an anticipated preferred dividend has unfavorable repercussions. Besides weakening investor confidence, the general credit, and future borrowing power of the company suffer.

Because most preferreds can be considered fixed-income securities, they do not offer the same potential for capital appreciation that common shares provide for investors. Should interest rates decline, the preferreds would increase in price, much like a bond. However, good corporate earnings would have no effect on the dividend rate or equity allocation. Therefore, the dividend rate is of prime importance to the preferred shareholder.

Key Takeaways

  • Preferred shareholders have a fixed income stream and rank ahead of common shareholders but behind creditors in the event of liquidation or bankruptcy.
  • Different classes of preferred shares exist, and they can rank pari passu if they hold the same status in terms of asset and dividend entitlement.
  • Preferred dividends are not obligatory and are declared at the discretion of the board of directors; however, failing to pay them could harm investor confidence and the company’s creditworthiness.
  • Preferred shares offer limited potential for capital appreciation but provide a steady income, which makes them similar to fixed-income securities like bonds.

Frequently Asked Questions (FAQs)

Q1: What does pari passu mean in the context of preferred shares?

A1: Pari passu is a Latin term meaning “equal footing.” In the context of preferred shares, it means that multiple classes of preferred shares have equal rank and priority in terms of asset and dividend entitlement.

Q2: How are preferred dividends different from interest payments on bonds?

A2: Unlike interest payments on bonds, preferred dividends are not mandatory. They are paid at the discretion of the board of directors and only if declared. However, not paying dividends can have negative effects on the company’s reputation and credit standing.

Q3: Why don’t preferred shares offer significant capital appreciation?

A3: Preferred shares are similar to fixed-income securities; they are valued primarily for their steady dividend income rather than their potential for capital growth. As such, their price is more sensitive to interest rate changes than to corporate earnings.

Glossary

  • Fixed-Income Security: A type of investment that pays regular income, such as bonds or preferred shares.
  • Pari Passu: A term that means on equal footing, used to describe investments that have equal claim to payments or assets.
  • Dividend: A sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits (or reserves).
  • Par Value: The face value of a bond or share; the amount paid out at maturity for bonds or initial amount paid for shares.

CSC® Exams Practice Questions

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Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

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## What type of income stream do preferred shareholders usually receive? - [ ] Variable dividend based on earnings - [ ] No dividend at all - [x] Fixed dividend payment - [ ] Stock options > **Explanation:** Preferred shareholders normally receive a fixed dividend payment, subject to the discretion of the board of directors, making them akin to a type of fixed-income security. ## How do preferred shareholders rank in terms of claim to assets compared to common shareholders and creditors? - [ ] Ahead of creditors and common shareholders - [ ] Behind common shareholders, but ahead of creditors - [ ] On the same level as common shareholders - [x] Behind creditors, but ahead of common shareholders > **Explanation:** Preferred shareholders rank behind creditors but ahead of common shareholders in their claim to assets in the event of the company's bankruptcy or dissolution. ## What does it mean when preferred shares are described as 'pari passu'? - [ ] They rank behind common shares - [ ] They have no dividend entitlement - [x] They rank equally in terms of asset and dividend entitlement - [ ] They are convertible into common shares > **Explanation:** 'Pari passu' means that various preferred share issues have equal ranking in terms of their claim to assets and their entitlement to dividends. ## What is usually found in the 'preference as to assets' clause of most preferred share issues? - [ ] Preferred shareholders rank ahead of debtholders - [ ] Common shareholders have priority - [x] Preferred shareholders rank ahead of common shareholders but behind creditors and debtholders - [ ] Preferred shareholders have a claim to company earnings > **Explanation:** The 'preference as to assets' clause states that preferred shareholders rank ahead of common shareholders but behind creditors and debtholders in their claim to assets. ## What is the significance of the fixed dividend rate for preferred shareholders? - [ ] It changes based on company profits - [ ] It allows for significant capital appreciation - [x] It is the primary source of income and remains constant - [ ] It can be frequently modified by the board of directors > **Explanation:** Preferred shareholders usually receive a fixed dividend rate that provides a consistent income stream, unlike common shareholders who might benefit from company profits through variable dividends and capital appreciation. ## What happens if the board of directors omits the payment of a preferred dividend? - [ ] Preferred shareholders can take legal action - [x] Preferred shareholders have very little recourse - [ ] Common shareholders must vote on the omission - [ ] Preferred shareholders can convert their shares to debentures > **Explanation:** If the board of directors omits the payment of a preferred dividend, preferred shareholders generally have very little they can do aside from waiting until dividends are declared again. ## Which of the following describes the effect of not declaring expected preferred dividends? - [x] Weakening investor confidence and the company's credit status - [ ] Improvement of common shareholders' position - [ ] Increased value of preferred shares - [ ] Enhanced company earnings > **Explanation:** Not declaring expected dividends can weaken investor confidence and affect the company's credit status and future borrowing power negatively. ## When might dividends not be paid to common shareholders? - [ ] If preferred shareholders do not approve - [ ] Until bondholders receive interest payments - [ ] During a decline in stock price - [x] Until preferred shareholders have received full payment of their dividends > **Explanation:** Company charters often stipulate that common shareholders do not receive dividends until preferred shareholders have received full payment of their entitled dividends. ## How does a decline in interest rates affect the price of preferred shares? - [ ] It leads to a decline in preferred prices - [x] It leads to an increase in preferred prices - [ ] It has no effect on preferred prices - [ ] It makes preferred shares convert to common shares > **Explanation:** If interest rates decline, the price of preferred shares generally increases, similar to how the price of bonds behaves. ## Preferred shares and common shares offer different investment benefits. Which is accurate? - [ ] Preferred shares offer substantial capital appreciation - [ ] Common shares provide a fixed income stream - [x] Preferred shares offer fixed income, while common shares have potential for capital appreciation - [ ] Both offer the same risk level and income stream > **Explanation:** Preferred shares offer a fixed income stream, making them similar to fixed-income securities, while common shares provide potential for capital appreciation but usually do not offer a fixed income stream.

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