Understanding Dividends, Preferred Stock, Debt, and Equity in Corporate Finance

Dividends

• Unless a dividend is declared by the board of directors of a corporation, it is not a liability of the corporation (A corporation cannot default on an undeclared dividend)
• The payment of dividends by the corporation is not a business expense. (Therefore, they are not tax-deductible)
• Dividends received by individual shareholders are, for the most part, considered ordinary income by the IRS and are fully taxable (There is an intra-corporate dividend exclusion)

Preferred Stock

Preferred stock represents equity of a corporation, but is different from common stock because it has preference over common in the payments of dividends and in the assets of the corporation in the event of bankruptcy. They have a stated liquidating value (usually $100 per share). They are either cumulative or noncumulative.

Unlike debt, preferred stock dividends cannot be deducted as interest expense when determining taxable corporate income.

Features:

• Dividends
  • Stated dividend must be paid before dividends can be paid to common stockholders
  • Dividends are not a liability of the firm, and preferred dividends can be deferred indefinitely
  • Most preferred dividends are cumulative – any missed preferred dividends have to be paid before common dividends can be paid
• Preferred stock generally does not carry voting rights

Corporate Debt and Bank Loans

Debt

• Not an ownership interest
• Creditors do not have voting rights
• Interest is considered a cost of doing business and is tax deductible
• Creditors have legal recourse if interest or principal payments are missed
• Excess debt can lead to financial distress and bankruptcy

Equity

• Ownership interest
• Common stockholders vote for the board of directors and other issues
• Dividends are not considered a cost of doing business and are not tax deductible
• Dividends are not a liability of the firm, and stockholders have no legal recourse if dividends are not paid
• An all-equity firm cannot go bankrupt

Interest vs Dividends: Debt is not an ownership interest in the firm. Creditors do not usually have voting power. The corporation’s payment of interest on debt is considered a cost of doing business and is fully tax-deductible. Dividends are paid out of after-tax dollars. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the firm.

Types of debt: A debenture is an unsecured corporate debt, whereas a bond is secured by a mortgage on the corporate property. A note usually refers to an unsecured debt with a maturity shorter than that of a debenture, perhaps under 10 years.