Does anyone know if stock dilution (as we are hearing about in regard to Merrill Lynch) affects preferred shares as well as common shares?
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Not specific to Merrill...many possible scenarios here...
If the existing issue is a straight preferred, and the new issue is a common, then the dilution should have little effect because that preferred is little more than a dividend-payer (little/no upside potential). If anything new new capital should buy some time for the company to continue its preferred dividends, rather than suspending them (if things have gone so far south that there's a risk the company can't pay them). So that raise could benefit the preferred despite the dilution of common shareholders.
If the new issue is another class of preferred, and it has higher priority with respect to payment of dividends, or in liquidation/restructuring in bankruptcy, then yes the dilution affects the existing preferreds. Someone just got in line ahead of you, which could become an issue if there isn't enough to go around.
There is a general risk as well, regardless of type - that the terms of the capital raise signal to the market that the current state of the company is worse than perceived. For example when a common is issued at a price well below the current market price, that can affect the perception of the company and the value of its preferreds. The preferreds of a company teetering on the brink of bankrtupcy are almost as likely to become worthless as are the common shares.
Another scenario - if the existing preferreds are convertible to common shares, then the dilution affects the value of that embedded call option. It becomes less valuable, to the extent of the dilution, though that could be offset by improvement in the company's prospects for remaining in business. After all that convertible option is worth $0 if the company files for bankruptcy.
-Tad
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