2.7: Interest Paid on Bonds and Dividends Paid on Stock
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- 88495
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- Interest on debt is tax deductible to the corporation; dividends on preferred and common stocks are not tax-deductible, under current law.
- Interest must be paid before any dividend payments on preferred and common stocks may be made.
- Preferred stock dividends are usually fixed (like the interest on most bonds). Even if the corporation becomes more profitable, the preferred stock dividend cannot be increased. There is no upside, in this case.
- Only after interest is paid on the corporation’s debt, may preferred dividends then be paid. If the dividend is not paid, it is not considered a “default” as with a loan or debt; this is because preferred stock represents ownership interests and not a liability. Preferred stock is thus thought of as a hybrid debt/equity security as it has characteristics of both.
- Most preferred shares are “cumulative,” which means that before any dividends are paid to common shareholders, all those preferred dividends that have not been paid, and are thus said to have accumulated unpaid or “in arrears,”must first be paid2.
- Common stock is most risky– first, because its dividends are the last to be paid and secondly, because common shareholders are the last to be paid off in bankruptcy (thus the phrase “residual interest,” used above).
- However, as common shareholders have rights to “residual” profits (i.e., after interest is paid on debt and, second, after preferred stock dividend distributions) that the firm may generate, common shareholders also have the most opportunity to share in positive earnings growth, i.e., they have the most to gain.
- As a result, common shares usually come with “voting rights,” i.e., the ability annually to vote for company management and on certain key issues. Notably preferred shares rarely carry such rights.