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

Answer:

1. Dividend Payment Requirements:

a. Common stock dividend rates are not fixed, unlike the preferred stock dividends. They are not cumulative like cumulative preferred stock. They are only paid when the directors declare them.

b. Preferred stockholders usually have a fixed rate of dividend. They have preference over common stockholders in dividend payments. Some preferred stockholders enjoy cumulative dividends, unlike common stockholders.

2. Common stockholders expect higher dividends than the preferred stockholders because they bear the residual business risks associated with the company.

Explanation:

Dividend income results when management declares it to be paid to the stockholders.  They are usually paid out of earned income.  The discretion to declare dividends lies solely with management.  On the other hand, stockholders can decide to take advantage of the movements in stock prices at the stock exchange by earning capital gains through selling their shares.  This income is not at the discretion of management insofar as the entity is being run profitably.