Page 440 - Business Principles and Management

Chapter 16 • Financing a Business

Technology tip
corporation to take control away from the current stockholders by issuing and
buying a large amount of new stock.

PREFERRED STOCK It used to be difficult to track
stock market investments.
Preferred stock is stock that gives holders first claim on corporate dividends if a Investors had to rely on daily
company earns a profit. In addition, in the event a business fails, preferred stock- newspapers, financial reports
holders have priority over common stockholders on any remaining assets after on radio and TV, or communi-
creditors have been paid. However, preferred stockholders typically have no vot- cations with a stockbroker.
ing rights. Preferred stock carries a guaranteed fixed dividend. A corporation must Today information on the
use its earnings first to pay its debts. Then any remaining profits must go first to stock market and individual
preferred stockholders. Preferred stockholders receive their guaranteed dividend stocks is available almost
before common stockholders get anything. If any profits remain, the corporation instantaneously through
can then pay dividends to common stockholders. financial Internet sites. In-
For example, suppose that a corporation issues $100,000 of 7 percent pre- vestors create their own stock
ferred stock and $100,000 of common stock. Further assume that profits for the portfolios, which are tracked
year are $10,000. The preferred stockholders would receive 7 percent of $100,000, on their desktops along with
or $7,000. Only $3,000 would be left for the holders of common stock. Their breaking news that might
return on $100,000 would yield only 3 percent ($3,000/$100,000). Even that affect their investments.
return is not guaranteed because the board of directors may choose not to declare
a dividend for common stockholders.
A special class of preferred stock is cumulative preferred stock. If there is no
profit in a particular year, the guarantee remains in place for cumulative preferred
stockholders, so the dividend will have to be made up in future years when the
company is profitable again.
Preferred stockholders have priority over common stockholders with regard
to not only dividends but also assets. For instance, if the corporation ceases opera-
tions, its assets belong to its owners, the stockholders. The assets are first distrib-
uted to preferred stockholders. Any remaining assets go to common stockholders.
What would happen if a corporation with $500,000 of outstanding common
stock and $500,000 of outstanding preferred stock ceased operating? Assume that
after selling all of the assets for cash and after paying all of its creditors, $800,000
in cash remains. The sum of $500,000 (the par value of the preferred stock) must
be paid to the preferred stockholders, because their stock has asset priority. As a
result, the common stockholders would receive only $300,000, which is 60 percent
of the full value of their stock ($300,000/$500,000). If no stock had been issued
as preferred, all stockholders would share equally in the $800,000.

CHECKPOINT
What right do common stockholders have that preferred
stockholders do not?

The Value of Stock

The original sale of stock provides the equity that a company needs to operate
the business. It is used to finance long- and short-term assets and pay operating
expenses. Even though the value of stock may increase or decrease after the
original sale, that change in value is not directly reflected in the resources the

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