After reading this article you will learn about Preference Shares:- 1. Types of Preference Shares 2. Features of Preference Shares 3. Advantages 4. Disadvantages.
Types of Preference Shares:
Preference shares are of the following types:
(a) Cumulative Preference Shares:
These shares have a right to claim dividend for those years also for which there are no profits. Whenever there are divisible profits, cumulative preference shares are paid dividend for all the previous years in which dividend could not be declared.
Take for example, a company which is unable to pay dividend on preference shares for the years 1994 and 1995, if in the year 1996 the company has sufficient profits, cumulative dividend will be paid first for the years 1994 and 1995 and only then the dividend for the year 1996 will be declared. The dividend goes on cumulating unless otherwise it is paid.
(b) Non-Cumulative Preference Shares:
The holders of these shares have no claim for the arrears of dividend. They are paid a dividend if there are sufficient profits. They cannot claim arrears of dividend in subsequent years.
(c) Redeemable Preference Shares:
Normally, the capital of a company is repaid only at the time of liquidation. Neither the company can return the share capital nor the shareholders can demand its repayment. The company, however, can issue redeemable preference shares if Articles of Association allow such an issue. The company has right to return redeemable preference share capital after a certain period.
The Companies Act has provided certain restrictions on the return of this capital. The shares to the be redeemed should be fully paid up. The company should redeem these share either out of profits or out of fresh issue of capital. The object of these restrictions is that the resources of the company are not depleted.
(d) Irredeemable Preference Shares:
Those shares which cannot be redeemed unless the company is liquidated are known as irredeemable preference shares.
(e) Participating Preference Shares:
The holders of these shares participate in the surplus profits of the company. They are firstly paid a fixed rate of dividend and then a reasonable rate of dividend is paid on equity shares. If some profits remain after paying both these dividends, then preference shareholders participate in the surplus profits. The mode for dividing surplus profits between preference and equity shareholders is given in the Articles of Association.
(f) Non-Participating Preference Shares:
The shares on which only a fixed rate of dividend is paid are known as non-participating preference shares. These shares do not carry the additional right of sharing of profits of the company.
(g) Convertible Preference Shares:
The holders of these shares may be given a right to convert their holdings into equity shares after a specific period. These are called convertible preference shares. The right of conversion must be authorised by the Articles of Association.
(h) Non-Convertible Preference Shares:
The shares which cannot be converted into equity shares are known as non-convertible preference shares.
Features of Preference Shares:
Preference shares have several features. Some of them are common to all the types of preference shares while others are specific to some of them. The following are the most significant features of preference shares:
Generally, preference shares resemble equity shares in respect of maturity. These are perpetual (irredeemable) and the company is not required to repay the amount during its life time. It is only at the time of liquidation that a company has to repay the preference shareholder after meeting the claim of creditors but before paying back the equity shareholders.
However, a company may issue redeemable preferences shares with a limited life after which these are supposed to be retired or paid back. The terms of the issue of preference shares may contain a call feature by which the company may call or buy back the shares at a specific price.
According to the Companies Act, 1956 a company can issue redeemable preference shares if authorised by its Articles of Association.
Section 80 of Act, provides that redeemable preference shares can be redeemed:
(i) Only if these are fully paid;
(ii) Redemption may be made either out of accumulated profits or out of the proceeds of a fresh issue Of shares;
(iii) If shares are to be redeemed out of accumulated profits, the amount required must be transferred to Capital Redemption Reserve Account and,
(iv) If shares are to be redeemed at premium, it should be provided either out of the accumulated profits or Share Premium Account.
(ii) Claims on Income:
A fixed rate of dividend is payable on preference shares. Preference shareholders have prior claim on income (dividend) over equity shareholders. Whenever the company has distributable profits, the dividend is first paid on preference share capital.
Only after payment of stipulated dividend on preferred stock, the company can pay any dividend to other (equity) shareholders. But, like equity shareholders, the holders of preference shares also cannot legally demand payment of dividends or distribution of earnings, as it is the prerogative of the management to decide whether to pay dividend or to reinvest its earnings.
However, the rate of dividend on preference shares, unlike equity shares, is fixed and they do not have share in the extra earnings of the company. But, a company may issue participating preference shares giving its holders a right to participate in the surplus profits of the company. In the same manner, a company may issue cumulative preference shares.
The cumulative feature gives right to its holders to claim arrears of dividend in the sense that in the event of non-declaration of dividends in any year, the same will not lapse and will be carried forward till the same is paid. A company may also issue cumulative convertible preference shares (CCPS) which are convertible into equity shares after the expiry of a certain period.
(iii) Claims on Assets:
Preference shares have a preference in the repayment of capital at the time of liquidation of a company. Their claims on assets are superior to those of equity shareholder. In the event of winding up of the company, their claim is to be settled first before making any payment to the equity shareholders.
But as they are not real owners of the company, the preference shareholder, usually, do not have any right in the surplus assets of the company. However, a company may issue participating preference shares which entitle its holders right to participate even in the surplus assets of the company at the time of liquidation in agreed ratio.
Ordinarily, preference shareholders do not have any voting rights; so they do not have any say in the management or control of the company. However, under section 87 of the Companies Act, 1956, preference shareholders can vote on a resolution which directly affects the rights to be attached to their preference shares.
They can also vote on every kind of resolutions placed before the meeting of the company if the dividend due on the their shares or any part there of has remained unpaid. In these situations, their right to vote shall be in the same proportion as the paid up preference share capital bears to the total paid up equity capital of the company.
(v) Hybrid Form of Security:
Preference share capital, in the real sense, represents a hybrid form of security as it includes some features of equity and other of debt financing.
It resembles equity in the sense that:
(i) Payment of dividend is not obligatory;
(ii) Preference dividend is payable only out of distributable profits and,
(iii) It is not deductible as an expense while determining tax liability of the company.
At the same time, it has certain characteristics of debt financing such as:
(i) It carries a fixed rate of dividend like interest;
(ii) It entitles to a right to its holder prior to equity shareholders and
(iii) It does not provide a right to vote.
Advantages of Preference Shares:
Preference shares provide a number of advantages both to the company as well as investors or shareholders.
(a) Company’s Point of View:
The company has the following advantages by issuing the preference shares:
(i) There is no legal obligation to pay dividend on preference shares. Preference dividend is payable only out of distributable profits at the discretion of the management. Hence, a company does not face a financial burden or legal action if it does not pay dividend.
(ii) Preference shares provide a long-term capital for the company.
(iii) There is no liability of the company to redeem preference shares during the life time of the company. Even in case of redeemable preference shares, they have to be redeemed either out of accumulated profits or out of the proceeds of a fresh issue of shares. Further, there are no significant penalties for delaying redemption of preference shares.
(iv) Redeemable preference shares have the added advantage of repayment of capital whenever there are surplus funds with the company.
(v) As a fixed rate of dividend is payable on preference shares, these enable a company to adopt trading on equity i.e. to increase rate of earnings on equity shares after paying a lower rate of fixed dividend on preference shares.
(vi) As preference share capital is generally regarded as part of company’s net worth, it enhances the credit worthiness of a firm.
(vii) Preference shares do not carry voting rights under normal circumstances and hence there is no dilution of control.
(viii) As no specific assets are pledged against preferred stock, the mortgageable assets of the company are conserved.
(b) Investor’s Shareholder’s Point of View:
Investors in preference shares enjoy the following advantages:
(i) It earns a fixed rate of dividend.
(ii) It is a superior security over equity shares.
(iii) It provides preferential rights in regard to payment of dividends and repayment of capital at the time of liquidation of the company. Hence, such investors who prefer safety of their capital and want to earn income with greater certainty always prefer to invest in preference shares.
(iv) Preference shares although carry no voting rights, but the holders of such shares can vote on matters directly affecting their rights as well as on all resolutions if the dividend due on their shares is remaining unpaid.
Disadvantages of Preference Shares:
In spite of many advantages, preference shares suffer from many shortcomings:
(a) Company’s Point of view:
The following are the main disadvantages of preference shares from the company’s point of view:
(i) It is an expensive source of finance as compared to debt because generally the investor’s expect a higher rate of dividend on preference shares as compared to the rate of interest on debentures. This is so because of high risk factor as compared to debt.
(ii) Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned.
(iii) Although there is no legal obligation of a company to pay dividend on preference shares, but frequent delays or non-payment adversely affect the creditworthiness of the firm.
(iv) Preference share dividend is not a deductible expense while calculating tax while interest is a deductible expense. Thus, there is a tax disadvantage to the company.
(v) In some cases, preference shares carry even the voting right and hence the control and„ management of the company may be diluted.
(b) Shareholder’ Point of View:
Investors suffer from the following demerits of preference shares:
(i) As the preference shareholders ordinarily do not have any voting rights, they remain at the mercy of the management for the payment of dividend and redemption of their capital.
(ii) The rate of dividend on preference shares is usually lower as comported to the equity shares.
(iii) Preference shareholders do not have any charge on the assets of the company while debentures, usually, provide a charge on all the assets of the company.
(iv) The market prices of preference shares fluctuate much more than that of debentures.