In this Article, we are going to discuss about Preference Shares Meaning, Features, Advantages, Disadvantages. Investing in stock Market Notes
Table of Contents
Preference Shares Meaning
According to Sec. 43 (a) of the Companies Act 2013, a share that carries the following two preferential rights is called ‘Preference Share’:
(i) Preference shares have a right to receive dividend at a fixed rate before any dividend given to equity Shares.
(ii) Preference shares have a right to get their capital returned, before the capital of equity shareholders is returned in case the company is going to wind up.
In case of preference shares, the rate of dividend is fixed and the dividend on these shares must be paid before any dividend is paid to equity share holders. Directors, however, may decide not to pay any dividend to any class of shareholders even if there are sufficient profits.
Preference Shares Features
1. Cumulative Dividends: Preference shares have dividend provisions which may be cumulative or non- cumulative. Most shares have the cumulative provisions, which mean that if company is not able to pay preference dividend due to shortage of profits, than such dividend paid in subsequent years in which company have sufficient profits.
2. Fixed Preferential dividend: Rate of dividend is fixed in case of preference shareholders. Also such dividends are paid in preference to equity shares.
3. Voting Rights: Preference shareholders do not carry the voting right. They can vote only if preference dividend is not paid for a period of two years or more.
4. Participating Preference Shares: The participating preference shareholder receives stipulated dividend and also get additional dividends with the common shareholders if the company’s earning is huge.
5. Par Value: Most preference shares have a par value. When it does, the dividend rights and call price are usually stated in terms of the par value. However, those rights would be specified even if there were no par value.
6. Redeemable Preference Shares: Typically, preference shares have no maturity date. In this respect it is similar to equity shares. But in present market, maximum company issue preference shares which are redeemable after a fixed period of time.
7. Preference in repayment of capital: Preference shares have a right to get their capital returned, before the capital of equity shareholders is returned in case winding up of a company.
8. Participation in Management: Since preference shareholders are secondary owners, they do have right to take part in the management of company.
9. Convertibility: Preference shares can be converted into equity shares if the terms of issue so provide.
Preference Shares Advantages and Disadvantages
Preference shares are beneficial for both company and investors.
Advantages of Preference Shares from Company’s Point of View
Some of the advantages of Preference shares from company’s point of view are given below:
1. Absence of voting rights: The preference shareholders do not have voting rights and they do not take part in the management of company. There is thus no interference in general by the preference shareholders.
2. Fixed return: The dividends to be paid to the preference shareholders are fixed as compared to the equity shareholders. The company can thus maximize the profits of equity shareholders.
3. Absence of charge on assets: Because preference shares are unsecured and it is a part of owner’s equity, so no charges are levied on the assets of the company unlike in the case of debentures.
4. Capital structure flexibility: By means of issuing redeemable preference shares, flexibility in the company’s capital structure can be maintained because redeemable preference shares can be redeemed under the terms of issue.
5. Absence of financial burden: Since preference dividend is paid out of profits only, it does create any financial burden on company if company is not able to generate profits.
6. Widening of the capital market: The scope of a company’s capital market is widened as a result of the issuance of preference shares because of the reason that preference shares provide not only a fixed rate of return but also safety to the investors.
Advantages of Preference Shares from the Investor’s Point of View
There are certain advantages of preference shares from the investor’s point of view. The advantages are as follows:
1. Fixed regular income: The cumulative preference shareholders get a fixed dividend income from the profits of the company. Even in case of loss, cumulative preference shareholders have the right to receive the arrear of dividend from subsequent year’s profits.
2. Safety of interest voting rights: Normally, Preference shareholders do not carry the voting right. They can vote only if preference dividend is not paid for a period of two years or more.
3. Less capital losses: The preference shareholders possess the preference rights of the repayment of their capital in the event of winding up of company. As a result of which there are less capital losses.
4. Proper security: Preference shareholders possess proper security in case when the company fails to generate profits or company is winding up.
5. Presence of preferential rights: When it comes to payment of dividend and repayment of capital, preference shareholders enjoy preferential rights.
Disadvantages of Preference Shares from company’s point of view
The disadvantages of preference shares, from the point of view of the company are as follows:
1. High rate of dividends: The Company has to pay higher rates of dividends to the preference shareholders as compared to the equity shareholders. Thus the cost of capital of the company is also increased.
2. Dilution of claim over assets: Because of the very reason that preference shareholders have preferential rights over the company assets in case of winding up of the company, dilution of equity shareholder’s claim over the assets of the company take place.
3. Tax disadvantages: In case of preference shareholders, the taxable income of the company is not reduced while in case of debentures, the taxable income of the company is reduced.
4. Effect on credit worthiness: In case of preference shares, the credit worthiness of a company is definitely reduced because preference shareholders possess the right over the assets of the company in the event of winding up.
5. Increase in financial burden: Because most of the preference shares issued are cumulative in nature, the financial burden on the part of the company increases significantly. Arrears of dividend of current year must be paid by the company if profits are generated in subsequent years.
Disadvantages of Preference Shares from Investor’s point of view
There are certain disadvantages of preference shares from the investor’s point of view. The disadvantages are as follows:
1. Absence of voting rights: Except in matters directly affecting the interest of preference shareholders, the preference shareholders have no voting rights.
2. Absence of guarantee over assets: The Company provides no guarantee on the assets of the preference shareholders. In case of huge loss or winding up of a company, repayment of capital of preference shareholders is made only when any surplus money is left after paying the obligations of secured creditors.
3. Fixed income: Dividend of preference shareholders is fixed. In cases where the company generates exceptional profits, no additional payment is given to preference shareholders. The preferential shareholders have no claim over the surplus profits of the company except in case of participating preference shares.
Preference Shares Types
Preference shares may be classified according to the rights attached to them as follows:
1. Cumulative and Non-cumulative Preference shares
Cumulative preference shares enjoy the right to receive the arrears of dividend of earlier years in which company earned no profits or insufficient profits, in the year in which company earns profits.
In case of non-cumulative preference shares dividend does not accumulate and therefore, no arrears of dividend will be paid in the subsequent years in which company earns profits. If company does not have any profits in a year, no dividend will be paid to non-cumulative preference shareholders.
2. Participating and Non-participating Preference Shares
The holders of participating preference shares have a right to participate in the surplus profits of the company remained after paying dividend to the equity shareholders and preference shareholders at a fixed rate.
The preference shares which do not have such right to participate in surplus profits, are known as non-participating preference shares.
3. Redeemable and Irredeemable Preference Shares
According to Section 55(2) of the Companies Act 2013, the Redeemable Preference shares are preference shares which have to be repaid by the company after expiry of the term for which the preference shares have been issued. Maximum period for which redeemable preference shares are issued is 20 years.
Irredeemable Preference shares means preference shares which need not repaid by the company except on winding up of the company. However, under the Indian Companies Act 2013, a company cannot issue irredeemable preference shares.
4. Convertible and Non-convertible preference shares
Where the preference shareholders are given a right to convert their equity shares into preference shares within a specified period of time, such shares as known as convertible preference shares.
Those shares, which do not carry the right of conversion into equity shares, are called non-convertible preference shares.