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Disadvantages of Preferred Stock – 5 Major Disadvantages | Corporate Finance

What do you mean by 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.

It represents a long term source of financing. In between the common stock and long term debt, it holds an intermediate position regarding claim on assets and dividend payment. One of the thing that should be noted is that nonpayment of preference dividends does not force the company into bankruptcy and dividend is paid out of after-tax profit.

Disadvantages of Preferred Stock

From the firm’s viewpoint the major disadvantages of preferred stock financing are as follows:

a) Expensive source of long-term financing:

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

b) Static Dividend:

The preferred stock dividend is fixed and the company must have a 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 in preferred stocks because they get only a fixed amount of dividend even though the firms earning is too high.

Besides, if the earning of the firm is low or unstable investors may not get the preferred dividend. Hence, it is difficult to sell 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 dividends to the preference shareholders.

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