The primary advantage to an investor of holding preferred stock compared with common stock is that the preferred stock return is somewhat more predictable (more certain). The issuing company will generally make a real effort to try to avoid defaulting on the preferred stock dividend. Since the return to preferred stock is reasonably well defined and since the preferred stockholders precede the common stockholders (the preferred dividends are paid before the common dividends), preferred stock is a popular type of security for executing mergers and acquisitions.
From the point of view of an issuing corporation’s common stockholders, preferred stock offers the opportunity to introduce a form of leverage that could benefit the common stockholders if the corporation does very well in the future. The preferred stockholders do not normally participate in any bonanza that might occur since their dividend rate is either fixed or, if variable generally has a set maximum. It is wrong to assume that preferred stock fills a unique demand for an investment security in the market that other securities cannot fill.
Dividends from common stock are as eligible for the dividend-received deduction available to corporate investors as preferred stock. Second, a portfolio of a firm’s debt and common stock can be constructed to have a return that behaves closely to the return on preferred stock. Although preferred stock may appear to a corporate issuer to be more desirable than common stock because of its financial leverage characteristics, this advantage is likely to be illusory.
With the present tax law, preferred stock has no special attributes for which an efficient market would be willing to pay a premium; thus, its cost is not likely to be cheaper than other forms of financing. If the types of risks associated with an investment in common stock and preferred stock purchased individually (not a mixture) are what the market desires and if the risks and returns could not be exactly duplicated in any other way, then it would be possible for a firm with preferred stock outstanding to sell at a premium.
As a theoretical as well as a practical matter, it is unlikely that the investors need the preferred stock to accomplish their investment objectives. If an explanation is to be found for the issuance of preferred stock, it is likely to be found in institutional considerations. The issuing corporation does not have a tax shield with either preferred stock or common stock, so there is no advantage for the corporation issuing preferred stock to be found in the tax laws.
The common stock can give rise to retained earnings (deferring taxes to the investor) and the prospect of capital gains from these retained earnings. The preferred stock does not offer these possibilities; thus, it is at a disadvantage. For zero-tax investors, neither preferred stock nor common stock has any specific advantage for the investor. Debt is likely to be more desirable than either security because of the tax shield provided to the issuer by the interest expense.