Sinking Funds Because there is no legal obligation to pay the preferred dividend and

Sinking Funds Because there is no legal obligation to pay the preferred dividend and

because bondholders and other creditors get the first crack at a firm’s income and liquidation rights, preferred shareholders want some assur- ance they will receive preferred stock dividends. A corporation can pro- vide this assurance in the form of a sinking fund provision. In fact, almost all preferred stock has a sinking fund provision.

As we discussed in Chapter 15 in the context of long-term debt, a sinking fund is like a savings account. The corporation deposits funds with a trustee, who uses these funds to periodically retire preferred stock, buying it from shareholders at a specified price, the sinking fund call price. The trustee acquires these shares by either buying them in the open market—calling up a broker and buying the shares—or calling in the preferred stock at a specified sinking fund call price. The amount of

FINANCING DECISIONS

the periodic retirement is predetermined, which may be specified in terms of the number of shares or the percentage of total shares to be retired each year. By retiring preferred stock periodically, the firm is bet- ter able to meet the dividend payments on the remaining preferred shares.

Packaging Features

A corporation may combine any of the features we just described into its preferred stock. If they hope to sell their preferred shares, they must pack- age them in a way that is attractive to investors and at a reasonable cost.

Features that give the issuer flexibility, such as a call feature, intro- duce uncertainty for investors. Investors do not know when (or if) the firm will call in the issue. Because investors do not like risk, they will demand a greater return on callable preferred shares to compensate them for the additional risk implicit in its uncertainty. Providing a greater return increases the issuer’s cost.

Features that give the investor something of additional value, such as a conversion feature, lower the issuers’ cost. Investors are willing to accept a lower return in exchange for convertibility. And if investors are willing to accept a lower return, the issuer’s cost of capital is lower.

And like common stock, dividends received by corporations are par- tially excluded from taxation. And because most of the investors in pre- ferred stock are corporations, the dividend received deduction lowers the return demanded by investors, lowering the issuing corporation’s cost of financing.

Packaging a new issue of preferred stock requires considering inves- tors’ need for greater returns and lower risk and the issuer’s need for greater flexibility and lower costs.

CORPORATE USE OF PREFERRED STOCK Preferred stock is generally considered the Wall Street wallflower. Seldom

issued, preferred stock is usually associated with financially troubled firms. Recently, several major U.S. companies issued preferred stock as a source of additional equity capital. Examples of preferred stock issues in the 1990s include Ford Motor Company, RJR Nabisco Holdings, Kmart, and General Motors. These issues did not do much to change preferred stock’s image, since these companies issued preferred stock at times when they were cash-poor or on the brink of a debt downgrade.

Why would a company issue preferred stock? One advantage of using preferred stock as a source of capital is that, in general, the firm must pay

Preferred Stock

only a fixed amount in dividends, leaving the upside potential in earnings to be reaped by common shareholders. Another advantage is that the vot- ing control of common shareholders is not diluted, as it would be if com- mon shares were issued. Still another advantage is the cost of preferred stock. Preferred stock is considered less risky than common stock, there- fore its cost to the issuer should be less than that of common stock. Rela- tive to issuing debt, preferred stock is more expensive since the interest paid on debt is deductible for tax purposes and the dividends paid on pre- ferred stock is not deductible.

Mitigating this cost somewhat is the fact that a large portion (cur- rently 70%) of the dividends received by corporate owners of preferred stock is excluded from taxable income, which therefore reduces the yields that corporate investors demand on the stock For example, if Corporation A owns the preferred stock of Corporation B, then only $30 of each $100 that A receives in dividends from B will be taxed at A’s marginal tax rate. The purpose of this provision is to mitigate the effect of the double taxation of corporate earnings. There are two implica- tions of this tax treatment of preferred stock dividends. First, the major buyers of preferred stock are the treasurers of corporations seeking tax- advantaged investments. Second, the cost of preferred stock issuance is lower than it would be in the absence of the tax provision, because the tax benefits are passed through to the issuer by the willingness of buyers to accept a lower dividend rate.

A disadvantage of preferred stock, relative to common stock, is that it has a claim on income and assets of the firm that is senior to that of common shareholders. The firm must pay the dividends owed preferred shareholders before it pays dividends to common shareholders.

Another disadvantage of using preferred stock as a source of capital is the connotation associated with these issuing firms. Historically, pre- ferred stock issuances have been made by firms that were in financial difficulty. This is confirmed by looking at what happens to a firm’s com- mon stock price when it announces an issue of preferred stock: The price of the issuer’s common shares tends to go down. For example, when RJR Nabisco Holdings announced a planned offering of $2 billion of preferred stock in 1994, its common stock price fell 8.5%. A portion of this fall in price may be attributed to the possible dilution of existing common shares since the planned preferred shares are convertible. However, the common stock price drop may also be attributed to the relatively high dividend yield needed to convince investors to buy the preferred stock and to the message conveyed by the firm that it was unable to successfully offer new common shares directly to the public.

FINANCING DECISIONS