Reasons for Issuing Preferred Stock

Corporations issue preferred stock for several reasons. One is to raise capital without sacrificing control. For example, suppose a company’s organizers have $100,000 cash to invest and organize a corporation that needs $200,000 of capital to start. If they sell $200,000 worth of common stock (with $100,000 to the organizers), they would have only 50% control and would need to negotiate extensively with other stockholders in making policy. However, if they issue $100,000 worth of common stock to themselves and sell outsiders $100,000 of 8%, cumulative preferred stock with no voting rights, they retain control.

A second reason to issue preferred stock is to boost the return earned by common stockholders. To illustrate, suppose a corporation’s organizers expect to earn an annual after-tax income of $24,000 on an investment of $200,000. If they sell and issue $200,000 worth of common stock, the $24,000 income produces a 12% return on the $200,000 of common stockholders’ equity. However, if they issue $100,000 of 8% preferred stock to outsiders and $100,000 of common stock to themselves, their own return increases to 16% per year, as shown in Exhibit 13.12.

EXHIBIT 13.12 Return to Common Stockholders When Preferred Stock Is Issued

Common stockholders earn 16% instead of 12% because assets contributed by preferred stockholders are invested to earn $12,000 while the preferred dividend is only $8,000. Use of preferred stock to increase return to common stockholders is an example of financial leverage Earning a higher return on equity by paying dividends on preferred stock or interest on debt at a rate lower than the return earned with the assets from issuing preferred stock or debt; also called trading on the equity. (also called trading on the equity). As a general rule, when the dividend rate on preferred stock is less than the rate the corporation earns on its assets, the effect of issuing preferred stock is to increase (or lever) the rate earned by common stockholders.

Point: Financial leverage also occurs when debt is issued and the interest rate paid on it is less than the rate earned from using the assets the creditors lend the company.

Other reasons for issuing preferred stock include its appeal to some investors who believe that the corporation’s common stock is too risky or that the expected return on common stock is too low.