Set out the kinds of equity security
The idea
Common shares carry a residual claim on assets and earnings and normally carry votes; they may be callable or putable, which alters the risk each side bears. Preference shares rank ahead of common for dividends and in liquidation, usually without votes, and may be cumulative, meaning missed dividends accrue and must be paid before any common dividend, or non-cumulative. They may also be participating, sharing in profits above a threshold, and convertible into common. The classification matters because a preference share with a fixed cumulative dividend behaves far more like a bond than like equity.
A practice question
What does cumulative mean in the context of preference shares?
- The dividend rate rises automatically with each year of the share's lifeWhy not: That would be a step-up or escalating dividend. Cumulative says nothing about the rate, only about what happens to a payment that is skipped.
- Missed dividends accrue and must be paid before any common dividend - correct
- Dividends are reinvested automatically in additional preference sharesWhy not: That is a reinvestment plan, an arrangement about what the holder does with a dividend once received.
Preference shares pay a fixed dividend. Cumulative means that if a dividend is skipped, it is not lost. The unpaid amount, called arrears, is carried forward and must be paid in full before common shareholders get anything. Formula: Amount owed = Annual dividend x (years missed + current year). For example, with a $2 dividend, two years skipped and a common dividend wanted in year three, the company must first pay 2 x 3 = $6 per share. Arrears are not a debt that can force the company into default, but they rank ahead of common holders.
A harder one
Which feature makes a common share less risky for its holder?
- A put feature, letting the holder sell it back at a set price - correct
- A call feature, letting the issuer redeem itWhy not: The issuer holds this option and will exercise it when it suits them, which caps the holder's upside.
- Cumulative votingWhy not: A mechanism for electing directors that helps minority holders get representation. It does nothing to the risk of the cash flows.
A put feature gives the holder the right to sell the share back to the issuer at a fixed price. Payoff on put = Put price (a floor), whatever the market does. If the put price is $15 and the market price falls to $8, the holder still receives $15, so the loss is limited. The holder owns this option, so the risk moves to the issuer. A call feature works the other way: the issuer can buy the share back, usually after the price has risen, which caps the holder's gain. Cumulative voting only changes how directors are elected and does not change the risk of the cash flows.
The hardest tier
How does a putable common share shift risk relative to an ordinary one?
- It gives the holder the right to sell back at a set price - correct
- It gives the issuer the right to repurchase, reducing the holder's upsideWhy not: Describes a call. A put is held by the investor, and an option is worth something to whoever holds it.
- It has no effect on risk, only on votingWhy not: The right to sell back at a set price puts a floor under the holding, which is a change in risk and shows in the price.
A put is the right to sell something at a set price. A putable common share lets the holder sell it back to the issuer at that price, so there is a floor under the holder's loss. For example, if the put price is $50 and the market price falls to $35, the holder can still sell back at $50. Downside risk moves from the holder to the issuer, so the share is worth more than an identical ordinary share. A callable share is the reverse, because the right belongs to the issuer.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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