Fact that preferred shareholders rank behind debtholders in the event of liquidation makes the presence of preferred shares, rather than more debt, of great value to the corporate lenders.
To understand the rights and characteristics of the different means of financing, we examine the powers accorded to shareholders under each arrangement. In the case of common stock, everything revolves around three key rights, namely, the residual claim to income, the voting right, and the right to purchase new shares. We examine each of these in detail and then consider the rights of preferred shareholders.
All income that is not paid out to creditors or preferred shareholders automatically belongs to common shareholders. Thus we say they have a residual claim to income. This is true regardless of whether these residual funds are paid out in dividends or retained in the corporation. Take, for example, a firm that earns $10 million available for common shareholders. Perhaps half of that will be paid out as common stock dividends. The balance will be reinvested in the business for the benefit of shareholders, with the hope of providing even greater income, dividends, and price appreciation in the future.
Realize, though, that the common shareholder does not have a legal or enforceable claim to dividends. Whereas a bondholder may force the corporation into bankruptcy for failure to make interest payments, common shareholders must accept circumstances as they are or attempt to change management if they desire a new dividend policy.
Occasionally a company has more than one class of common stock outstanding, carrying different rights and privileges. For example, Bombardier Inc. Class B shares have a higher dividend than Class A shares, but the Class B shares’ voting privileges are restricted. A somewhat recent innovation has come from General Motors Corporation in relation to two acquisitions. In October 1984 GM acquired Electronic Data Systems for cash and General Motors Class E common stock (total value, $2.5 billion), and in 1985 GM acquired Hughes Aircraft for cash and Class H common stock (total value, $5.8 billion). The dividends on the Class E stock are based on the income generated by EDS, and the dividends on the Class H stock are based on the earnings of Hughes Aircraft. While General Motors Class E and H shares are listed on the New York Stock Exchange, only the regular common GM common shares trade on Canadian markets as yet.
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