Question

Should preferred stock be classified as debt or equity? Does it matter if the classification is made by the firm’s management, creditors, or equity investors? Answer must be lengthy!! No Plagiarism!! Plagiarism will be checked!! Answer all parts of question!!

Answer 1

Preferred stock should be classified as equity and not as debt. Preferred stock is a hybrid instrument and shares some features of both debt as well as equity. The reason why preferred stock is classified as equity and not debt is that the holders of preference shares are entitled to receive a percentage share of the company’s profits and unlike debt preference shares have no capped payout. Debt instruments have a capped payout in the form of the agreed upon interest that is paid at regular intervals (half yearly or annual basis) but preferred stocks do not have a capped payout. It may sometimes have fixed dividends. Also owners of preferred stock have ownership in the company just like holders of common stock while debt instrument holders have no ownership in the company.

Yes it will matter if the classification is done by the firm’s management, creditors, or equity investors. All these entities will have a different stand point and a different view because of their different position and stand on the issue. Firm’s management will view preferred stock as an equity instrument as preferred stock is another class of ownership in a corporation. Creditors will view preferred stock as equity as claim of preferred stock holders will be lower on the assets and earnings of the company than the claim of creditors and bondholders. Equity investors will view preferred stock as debt as claim of preferred stock holders will be higher on the assets and earnings of the company than the claim of equity investors and common stock holders.