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

Preferred shareholders are guaranteed a fixed dividend whereas common stockholders have no guarantee. Only after preferred shareholders have been paid dividends for a financial year, then can the common shareholders get any dividend.

As there is a lot of uncertainty with regards to dividend for common stock i.e., common shareholders might not get any dividends, this is very risky investment for them hence to compensate for the risk they require higher return