Disadvantages of Preferred Stock – Corporate Finance | Management Notes

Disadvantages of Preferred Stock

Disadvantages of Preferred Stock
Preferred Stock | Corporate Finance
Management Notes

Disadvantages of Preferred Stock:

Preferred Stock which is also called preference share is a hybrid security with features of both debt and common stock which entitles the holder to pay a fixed dividend.Preferred shares generally have a dividend that must be paid out before dividends to common shareholders, and the shares usually do not carry voting rights.From the firm’s viewpoint the major disadvantages of preferred stock financing are as follows:

Disadvantages of Preferred Stock

a) Expensive source of long-term financing:

Preferred stock financing is expensive source of long-term financing because of two reasons:
i. Dividend rate on preferred stock is higher than interest rate payable on debentures.
ii.Unlike interest, preferred stock dividend is not tax-deductible expenses.

b) Static Dividend:

Preferred stock dividend is fixed and company must have commitment to pay this dividend. Although preferred stock dividends can be omitted, they may have to be paid because of their cumulative nature. Thus, preferred dividends are like fixed costs. The use of preferred stocks,like that of debt, increases financial risk and thus cost of common equity.

c) Difficulty to sell in the market:

Preferred Stock is difficult to sell in the market.Investors may not like to invest on preferred stocks because they get only fixed amount of dividend even though firm’s earning is too high. Besides, if the earning of firm is low or unstable investors may not get preferred dividend. Hence, it is difficult to sell the stocks.

d) Limited Increase in Value:

The share price of preferred stock usually remains fairly steady, so you have little chance of profiting from an increase in share value when you sell the stock. In fact, if interest rates increase, the value of your shares will decrease because investors are more interested in higher yielding bonds. They won’t be willing to pay as much for a stock with lower dividend rates.

e) Increase in financial burden:

Because most of the preference shares issued are cumulative,the financial burden on the part of the company increases highly.The company also reduces the dividend of the equity shareholders because of the reason that it is essential on the part of the company to pay the dividends to the preference shareholders.

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Author: Smirti

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