Question

There are two primary means to earn income as a stockholder. The first method is dividend income and the second method is earnings from capital gains. With respect to the investor seeking dividend income, when the investor buys a stock from a corporation with a primary focus to earn dividend income they will typically expect a higher dividend on common stock versus preferred stock. Discuss the dividend payment requirements of a common stock versus preferred stock, in terms of which type of stock has a primary claim on dividend distributions. Explain why the common stock investor demands a higher dividend rate.

Answer 1

Dividend Payment requirements of a common stock

Dividends are paid to the common stock shareholders after all other external liabilities like credit, loans, debenture interest, etc., have been paid and also dividend to preferred stock shareholders has been paid. There is no fixed percentage of dividend to be paid to the common stock shareholders when there are higher profits they are generally paid higher dividends and in case of lower profits, they get lower dividends. When a company is in loss or at break-even point there is no obligation to pay dividends to the common stock shareholders. Also, if no dividends are paid in the current year there is no provision regarding accumulating foregone dividends for the upcoming years. The dividend payment and dividend amount is entirely a managerial decision.

Dividend Payment requirements of a preferred stock

Dividends are paid to the preferred stock shareholders after all other external liabilities like credit, loans, debenture interest, etc., have been paid but before dividends to the common stock shareholders have been paid. Every year dividend is paid to preferred stock shareholders at a pre-determined fixed percentage. It is an obligation of the management to pay dividends to the preferred shareholders at that pre-determined fixed percentage even when the profits are low. If management decides to not to pay dividends to preferred stock shareholders due to lower profits or loss, their foregone dividends are accumulated for the upcoming years and paid in future. So, they have a particular sense of security with regards to their dividend payments.

Common stock investors demand a higher dividend rate because they have a higher risk as compared to preferred stock investors. Risk is associated with dividend payment requirements as well as the fact that in the case of liquidation of the company preferred stock shareholders are paid before the common stock shareholders are paid. Since common stock investors incur a higher risk their requirement for return in the form of dividend payments is also higher.