Understanding Common Stock and Preferred Stock in Corporate Finance
When it comes to financing options for a corporation, two primary categories emerge: debt financing and equity financing. In this blog post, we will dive into the world of equity financing, with a particular focus on common stock and preferred stock. Understanding these equity instruments is crucial for anyone interested in corporate finance. So, let’s get started.
Understanding Equity Financing
Before we dive into the specifics of common and preferred stocks, it’s essential to grasp the concept of equity financing. Equity financing involves raising capital by selling shares of ownership in the company. Unlike debt financing, where businesses take on loans that must be repaid with interest, equity financing allows companies to exchange ownership for funds without the obligation of repayment.
Common Stock: A Piece of the Company
What is Common Stock? Common stock is often what comes to mind when we think of equity financing. It represents ownership in a company and grants shareholders certain rights and privileges.
Ownership and Voting Rights When you own common stock in a company, you are a shareholder and, in essence, a part-owner. Common stockholders typically have voting rights in proportion to their ownership. For example, if you own 10% of a company’s common stock, you generally have a say in 10% of the company’s major decisions.
The Risks and Rewards Investing in common stock can be rewarding, but it comes with risks. Shareholders participate in the company’s profits, but they are also exposed to potential losses if the company doesn’t perform well in the market.
When individuals purchase common stock, they become shareholders, which means they have a stake in the company’s profits and losses.
One of the distinguishing features of common stock is the right to vote in corporate matters. Shareholders can vote on crucial decisions, such as electing the board of directors or approving mergers and acquisitions. However, it’s important to note that owning common stock doesn’t guarantee significant influence, as the number of votes typically corresponds to the number of shares held.
Preferred Stock: A Blend of Debt and Equity
A Hybrid Instrument Preferred stock is a unique hybrid instrument that combines features of both debt and common stock. Preferred stockholders do not have the same voting rights as common stockholders, but they enjoy some distinct advantages.
Priority Claims One of the key benefits of preferred stock is its priority claim to dividend distributions and assets in the event of a company’s liquidation. This means that, in case of financial trouble, preferred stockholders are among the first to receive their share of assets or dividends.
Preferred stock, on the other hand, occupies a unique space in the world of corporate finance. Preferred stockholders do not possess the same voting rights as common stockholders. This means they often have a limited say in corporate decisions. However, preferred stock comes with certain advantages.
Preferred stockholders enjoy a priority claim to dividend distributions. This means that when a company distributes profits, preferred stockholders are among the first to receive their share, ensuring a consistent income stream.
Also, in the event of a company’s liquidation, preferred stockholders hold a priority claim over common stockholders when it comes to recovering their investments. This provides a layer of security for those who invest in preferred stock.
Voting Mechanisms in Corporate Finance
Majority Voting
Making Decisions Majority voting is a critical concept in corporate governance. It refers to the process by which decisions are made within a corporation. In most cases, decisions are made based on a majority vote, meaning that the option with the most votes wins.
Implications for Governance Understanding majority voting is essential because it impacts how companies make decisions that affect their operations, growth, and direction.
Cumulative Voting
Empowering Shareholders Cumulative voting is another method used in corporate elections. It allows shareholders to have a more significant say in board member elections.
Calculations and Influence Shareholders can use cumulative voting to calculate the number of shares required to elect a specific number of board members or to determine how many board members they can elect with their shares.
Applications Beyond Corporate Finance
These voting concepts aren’t confined to the corporate world alone. They have applications in other settings, such as politics and not-for-profit organizations. Understanding majority voting and cumulative voting can provide valuable insights into decision-making processes in various contexts.
Calculate dividends on common stock
To calculate dividends on common stock, you need to know the following information:
- Dividend per Share (DPS): This is the amount of money paid to each shareholder for each share of common stock they own. It is usually expressed as a fixed amount per share or as a percentage of the stock’s par value or market price.
- Number of Outstanding Shares: This is the total number of common shares issued by the company and held by shareholders.
Once you have these two pieces of information, you can calculate the total dividends on common stock using the following formula:
Total Dividends on Common Stock = DPS x Number of Outstanding Shares
For example, if a company pays a dividend of $2 per share, and there are 1,000,000 outstanding shares, the calculation would be:
Total Dividends on Common Stock = $2 x 1,000,000 = $2,000,000
So, the total dividends on common stock for this company would be $2,000,000. This is the amount of money that the company would distribute to its common shareholders as dividends
Calculate dividends on preferred stock
To calculate dividends on preferred stock, you need to know the following information:
- Dividend Rate: This is the annual percentage rate at which the preferred stock pays dividends. It is usually expressed as a percentage of the stock’s par value or face value.
- Par Value of Preferred Stock: This is the nominal or face value of each preferred stock share, which is typically specified when the stock is issued.
- Number of Outstanding Preferred Shares: This is the total number of preferred shares issued by the company and held by shareholders.
Once you have these three pieces of information, you can calculate the annual dividends on preferred stock using the following formula:
Annual Dividends on Preferred Stock = Dividend Rate x Par Value of Preferred Stock x Number of Outstanding Preferred Shares
For example, if a company has preferred stock with a dividend rate of 5%, a par value of $100 per share, and there are 10,000 outstanding preferred shares, the calculation would be:
Annual Dividends on Preferred Stock = 5% x $100 x 10,000 = 0.05 x $100 x 10,000 = $50,000
So, the annual dividends on preferred stock for this company would be $50,000. This is the total amount of money that the company would distribute to its preferred shareholders as dividends each year, as long as the dividends are paid at the specified rate.
Conclusion
In the realm of corporate finance, common stock and preferred stock are pivotal instruments that shape ownership and influence within companies. Additionally, voting mechanisms like majority voting and cumulative voting are essential for understanding how decisions are made and who holds power in corporate governance. These concepts, while vital for the business world, also have broader applications, making them valuable tools for anyone interested in understanding how decisions are reached and power is distributed in various organizations.
Author: Simeon Bala
An Information technology (IT) professional who is passionate about technology and building Inspiring the company’s people to love development, innovations, and client support through technology. With expertise in Quality/Process improvement and management, Risk Management. An outstanding customer service and management skills in resolving technical issues and educating end-users. An excellent team player making significant contributions to the team, and individual success, and mentoring. Background also includes experience with Virtualization, Cyber security and vulnerability assessment, Business intelligence, Search Engine Optimization, brand promotion, copywriting, strategic digital and social media marketing, computer networking, and software testing. Also keen about the financial, stock, and crypto market. With knowledge of technical analysis, value investing, and keep improving myself in all finance market spaces. Pioneer of the following platforms were I research and write on relevant topics. 1. https://publicopinion.org.ng 2. https://getdeals.com.ng 3. https://tradea.com.ng 4. https://9jaoncloud.com.ng Simeon Bala is an excellent problem solver with strong communication and interpersonal skills.
