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2.7: Interest Paid on Bonds and Dividends Paid on Stock
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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
.
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Interest must be paid before any dividend payments on preferred and common stocks may be made.
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Preferred
stock
dividends are usually fixed (like the interest on most bonds).
Even if the corporation becomes more profitable, the preferred stock dividend
can
not
be increased. There is no upside, in this case.
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Only a
fter interest is paid on the corporation’s debt,
may
preferred dividends then be paid. If the dividend is not paid, it is not consid
ered a “default” as with a loan
or debt; this is because preferred stock represents ownershi
p interests and not
a
liability. Preferred stock is thus thought of as a hybrid debt/equity security
as it has characteristics of both
.
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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 paid
2
.
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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)
.
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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 ma
y generate
,
common shareholders
also
have
the most opportunity
to share in positive earnings growth
, i.e., they have the most to gain
.
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As a result, c
ommon 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.