In this lesson we will review callable preferred stock shares. We will also explore the benefits and disadvantages of these shares for both the corporation and the investors.
Callable Preferred Stock
The XYZ Corporation is finding itself in a financing dilemma. It would like to sell shares of stock to raise capital for continued growth.
In the long run, though, the company would like the ability to regain ownership of those shares once its objectives have been met. Callable preferred stock offers just this kind of opportunity. Let’s take a look at how this could work for XYZ.
First, let’s be sure that the XYZ leadership is clear about what this option entails. Shares of callable preferred stock are unique in that the shares are issued with the option for XYZ to repurchase those shares in the future at a designated price.
In exchange for the risk to investors, the preferred shares come with a guaranteed dividend rate and take priority over owners of common shares. This is what makes the shares belong to the preferred class, while callable refers to the ability of the company to buy back the shares at a specified call price, the price the issuer must pay investors if it calls back the stock before the stock’s date of maturity. Common shares of stock do not have a guarantee of specific dividends.These factors reduce risk for the company since it could recall those shares and then reissue new ones at a lower dividend interest rate. If interest rates in the market go up, the company does not have to recall the shares and can keep paying the lower dividend rate.
While investors lose out if rates go up, they have the advantage of being able to count on consistent dividends even if rates drop.
Let’s say that XYZ is attempting to raise $1,000,000 in equity by selling shares of preferred stock. It needs the money in order to finance its next big project, but would like to be able to buy back those shares at a later date if interest rates drop. XYZ creates 10,000 shares which sell for $100 each and each share pays an annual dividend of 5%. A call price of $106 is set, granting ZYX the right to buy back the shares at anytime for $106 each. Investors can rest assured that even if the shares were called in a year later they would receive the 5% dividend plus the $6 difference between the buy and call price.Two years later the prevailing interest rates have dropped to 2%, but XYZ shares are now worth $107 on the open market.
XYZ decides to call in the shares. At that time the company pays $1,060,000 to recover the shares. The great thing about this is that XYZ was able to buy the shares at $106 under the terms of the issue contract, which is below the fair market value. The company can then create new shares that offer a 2% dividend and carry a call price of $104.
XYZ is able to save the 3% difference in annual dividends which amounts to savings of $30,000 per year if the stock value remains at $100 per share.
Callable preferred stock shares are shares of equity in a corporation which carry an option for the corporation to buy the shares back at a designated call price. The stock is considered preferred because investors receive guaranteed dividends, while regular shares have no such guarantee. A company might want to buy back shares in order to make the company privately owned again in the future, or to be able to take advantage of changes in interest rates.
When rates drop the company can buy back the shares at the call price and then create new shares which offer a lower dividend. While this isn’t great for investors, they can still count on being able to receive a specific dividend for as long as they own the stock. Plus the investors get the benefit of knowing that if the shares are bought back by the company, they will be getting a guaranteed sale price.