Capital Sources for Business: Preference Shares

Preference shares are those which carry priority rights in regard to the payment of dividend and return of capital and at the same time are subject to certain limitations with regard to voting rights.  The preference shareholders are entitled to receive the fixed rate of dividend out of the net profit of the company. Only after the payment of dividend at a fixed rate is made to the preference shareholders, the balance of profit will be used for paying dividend to ordinary shares. The rate of dividend on preference shares is mentioned in the prospectus. Similarly in the event of liquidation the assets remaining after payment of all debts of the company are first used for returning the capital contributed by the preference shareholders.

Types of Preference Shares

  1. Cumulative and non-cumulative: In the case of cumulative preference shares, the unpaid dividend goes on accumulating until paid. The unpaid dividends on cumulative preference shares become payable out of the profit of the company in the subsequent years. Only after such arrears have been paid off, any dividend can be paid to other classes of shares. In case of non-cumulative preference shares, the right to claim dividend lapses if there is no profit in a particular year. Thus, the non-cumulative preference shareholders are not entitled to claim arrears of dividend. As a result, the dividend coupon on non-cumulative preference shares is more than that of cumulative preference shares.
  2. Participating and non-participating: The preference shares which are entitled to participate in the surplus of profits of the company available for distribution over and above the fixed dividend are called as participating preference shares. Non-participating preference shares do not have such rights.
  3. Convertible and convertible: Convertible preference shares are convertible into equity shares as per norms of issue and conversion. Non-convertible preference shares are not converted. Convertibility is resorted to enhance attractiveness of the instrument to prospective investors, who prefer equity to preference shares.
  4. Redeemable and Irredeemable: Redeemable preference shares are those which can be redeemed during the life time of the company, while irredeemable preference shares can be redeemed only when the company goes for liquidation.
  5. Cumulative Convertible: Cumulative convertible preference shares have both the features of cumulativeness of unpaid dividend and convertibility. These features make the preference shares more preferred.

Merits of Preference Shares

  • The preference shares have the merits of equity shares without their limitations.
  • Issue of preference shares does not create any charge against the assets of the company.
  • The promoters of the company can retain control over the company by issuing preference shares, since the preference shareholders have only limited voting rights.
  • In the case of redeemable preference shares, there is the advantage that the amount can be repaid as soon as the company is in possession of funds flowing out of profits.
  • Preference shares are entitled to a fixed rate of dividend and the company many declare higher rates of dividend for the equity shareholders by trading on equity and enhance market value.
  • If the assets of the company are not of high value, debenture holders will not accept them as collateral securities. Hence the company prefers to tap market with preference shares.
  • The public deposit of companies in excess of the maximum limit stipulated by the Reserve Bank of India can be liquidated by issuing preference shares.
  • Preference shares are particularly useful for those investors who want higher rate of return with comparatively lower risk.
  • Preference shares add to the equity base of the company and they strengthen the financial position of it. Additional equity base increases the ability of the company to borrow in future.
  • Preference shares have variety and diversity, unlike equity shares. Companies have thus flexibility in choice.

Demerits of Preference Shares

  • Usually preference shares carry higher rate of dividend than the rate of interest on debentures.
  • Compared to debt capital, preference share capital is a very expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense.
  • In the case of cumulative preference shares, arrears of dividend accumulate. It is a permanent burden on the profits of the company.
  • From the investors point of view, preference shares may be disadvantageous because they do not carry voting rights. Their interest may be damaged by a equity shareholders in whose hands the control is vested.
  • Instead of combining the benefits of equity and debt, preference share capital, perhaps combines the banes of equity and debt.

Credit: Financial Management Concepts-MGU

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