PREFERRED STOCK
Preferred stock is a hybrid—it is similar to bonds in some respects and to com-
mon stock in others. This hybrid nature becomes apparent when we try to clas-
sify preferred in relation to bonds and common stock. Like bonds, preferred
stock has a par value and a fixed dividend that must be paid before dividends
can be paid on the common stock. However, the directors can omit (or “pass”)
the preferred dividend without throwing the company into bankruptcy. So,
although preferred stock calls for a fixed payment like bonds, not making the
payment will not lead to bankruptcy.
As noted earlier, a preferred stock entitles its owners to regular, fixed divi-
dend payments. If the payments last forever, the issue is a perpetuity whose
value, Vp, is found as follows:
(9-8)
Vp is the value of the preferred stock, Dp is the preferred dividend, and r p is the
required rate of return on the preferred. Allied Food has no preferred outstand-
ing, but suppose it did, and this stock paid a dividend of $10 per year. If its
required return were 10.3 percent, then the preferred’s value would be $97.09,
found as follows:
In equilibrium, the expected return, rˆp, must be equal to the required return, r p.
Thus, if we know the preferred’s current price and dividend, we can solve for
the expected rate of return as follows:
(9-8a)
Some preferreds have a stated maturity, often 50 years. Assume that our
illustrative preferred matured in 50 years, paid a $10 annual dividend, and had a
required return of 8 percent. We could then find its price as follows: Enter N
50, I/YR 8, PMT 10, and FV 100. Then press PV to find the price, Vp
$124.47. If rp 10 percent, change I/YR to 10, in which case V p PV $100. If
you know the price of a share of preferred stock, you can solve for I/YR to find
the expected rate of return, rˆp.
Explain the following statement: “Preferred stock is a hybrid security.”
Is the equation used to value preferred stock more like the one used to evaluate a bond or the one used to evaluate a “normal,” constant growth common stock? Explain.
