Preference Shares

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A share is a small part of a large amount being distributed among people. It could be in any form of equity or preference shares.

Preference Shares Meaning

Preference shares are the shares that pledge with a fixed dividend to the holder, for whom payment takes precedence over the ordinary shareholders. 

  • Money raised by the preferential shares known as preferential share capital. 
  • Preference shareholders are superior over equity shareholders in 2 ways:
    • First, getting a set dividend rate from the company’s earnings, before any dividend is claimed for equity shareholders.
    • Second, getting their assets when the company’s creditors ‘ complaints have been resolved at the moment of liquidation. 
  • In brief, the preferred shareholders have the preferential claim over dividends as well as capital repayment relative to equity shareholders.

Dividends were payable at the directors’ discretion rather than out of profit after tax, to the extent which they resemble shares. Preference share resembles debentures though both bear a set rate of return to an owner.

Preferential shares, therefore, have some features of both debentures and equity shares.

But wait, I am getting a sense of preference shares,  but what are these equity shares in the first place? Let’s find out.


Equity Shares

Equity shares constitute the company’s ownership, along with the capital generated by these shares, is known as owner’s funds. They are the basis for a business to be created. 

  • Equity shareholders are paid on the grounds of a company’s income and do not receive a set dividend. They are called’ residual holders.’ 
  • They obtain what is left when all other claims have also been resolved on a company’s revenue and assets. 
  • Via their voting rights, these shareholders have the right to engage in the company’s leadership.

Ah, got it!


Preference Shares Capital

It implies the shares with preference over another equity capital of shareholders. This share capital prefers the dividend as well as repayment at a time of the liquidation.

Let us discuss this via an example of preference and equity share:

A company named PR limited following number of shares:

  • Equity share capital for 70 million, Seven million shares of 10,
  • Preference 7 million share capital, with 700,000 10 shares each.

In this, preferred shareholders have preferred rights over the firm’s shared equity.


Preference Shares Features

The perfect combination of features that preference shares have to make them different from equity and debt. The concepts may vary, but the following are common characteristics:

1. Preference in the assets upon liquidation: Shares give their holders priority at the time of liquidation of the company’s assets than common stockholders.

2. Dividend payments: The preference shares offer shareholders with a dividend. The payments could be fixed as well as floating, based on the benchmark of interest rates like LIBOR.

3. Preference in dividends: Priority to dividend payments over the common stockholders is given to preferred shareholders.

4. Voting rights: Basically, equity shareholders in the company are provided with voting rights.

Unlike equity shareholders, voting rights cannot be used by preference shareholders as they are already invested with a relatively dominant position in the company and thus have no voting right.

But preference shareholders of the company under some conditions can enjoy the right to vote.

Companies Act 2013 under Section 47(2) states that:

(a) In the company where each member with a limited number of preference shares shall be given voting rights on the basis of such capital.

  1. Any resolution regarding decreasing of equity or winding up of the company or for the repayment or preference shares
  2. (ii) Where resolutions enforce before the onset of the meeting effecting directly to the right to his preference shares
  3. (iii) Share and voting rights on a poll should be proportionately acquired in the company’s paid-up preference share capital.

5. Convertibility to common stock: Preference shares could be converted to the predetermined preferred stock number.

Most preferred shares determine the deadline the shares could be converted, whereas others require the consent of the management board.

6. Callability: At given dates, the shares could be repurchased by the issuer. 

7. Management discretion over the dividend payment: Payment of preference dividend was not mandatory and is a management choice.

Equity shareholders have no rights to claim dividends; its dividends were paid at the discretion of the management of the company.

8. There is no fixed maturity: A unique variant of preferential share maturity was not resolved such as equity shares. Its variant is commonly known as irredeemable shares of preferences.

For example, a preference share for Rs.100 might be convertible into 10 equity shares each of 10 Rs.

Factors like rights, privileges and also the convertibility aspect, conversion price and even the amount of shares provided at the moment of conversion were made clear in either a distinct clause when issuing convertible preference shares.


Preference Shares Types:

Following are the different variety of preference shares normally emitted by the company:

1. Cumulative Preference Shares

Unpaid preference dividends shall be paid first of all to shareholders. Unpaid preference dividends were named Arrearages. The delay should not exceed 3 years. There is no interest rate for the arrearages.

When provisions of Articles of an Association were available, At the time of Liquidation the arrearages are to be paid.

2. Non-cumulative Preference Shares

Dividends being paid depending on the revenues the company have availed.

When profit availability is not enough for all the preference dividend declaration, due to the failure of dividends in past years, such shareholders were not entitled, to get their share from the benefits of the organization.

However, they will always be given their share before the equity shareholders share.

3. Convertible preference shares:

Company issues these kinds of shares and has the right to transform these shares into the equity shares at a particular time. Typically, companies charge higher shareholders premiums during the transfer process.

Voting powers, issue of bonuses, higher dividends, depending on the availability of transformation rights. 

4. Redeemable preference shares:

The capital collected shall be subject to redemption/repayment under this category.

That means, whenever the preference shares show a specific repayment period, the reimbursable preference shares are perceived to be redeemable. 

5. Non-redeemable preference shares:

This type of share doesn’t have any specified time period of paying back the amount. However, when the winding-up of the company takes place, they have to repay. 

6. Participating preference shares:

This type of preference shares allows holders to share the benefits just after the dividends are given to equity shareholders and preference shareholders.

7. Not Participating preference shares:

These are the holders which cannot participate in any kind of decision making.


Preference Shares Advantages

Both issuers and securities holders get profit from preferred shares. Its issuers can get benefit from this:

  • No dilution of control: This type of funding let the issuers to be away from dilution of control as they don’t give voting rights.
  • No obligation for dividends: In this case, the company is not bound to give dividends to the shareholders. For example: – If the company doesn’t have sufficient money to pay dividends, it can simply delay payment. The company has this much power in decision making.
  • The flexibility of the terms: The management of the company has the flexibility to establish almost all terms for favourite shares. They can move according to the condition of the company i.e. whether profitable situation or lose.

Preference Shares Disadvantages

At the same time, here are a few concerns around preference shares that you must be aware of:

  • Preference dividends are not deductible from taxes and therefore are more expensive than debentures. 
  • If a company earns a profit, this brings a huge financial burden to the firm, as arrears dividend need to be paid in the event of the cumulative preference share. 
  • Redemption of a preference share produces financial burdens again and erodes it’s firm’s capital base.

Preference Shares Value: 

Preference shares provide dividend but don’t have a closing date. Shares for preferences are generally perpetuities, but they all have maturity deadlines sometimes.

Its value as the perpetuity of the preference share is measured as follows:

V = Preference Share Value

D = Annual Dividend each Preference Share

i = Discount price on a Preference Shares

V = D/i

Last year, the company selling preference share @ Rs. 60. By that moment, the discount price is 8%. The firm pays a yearly 5Rs dividend. The sort of preferential share presently yields 7%. So what’s the value of preference shares of a company?

V = 5/.07 = 71.42

The yield on the Preference Shares:

The yield on the Preference Shares was measured for the following manner: D

i = D/V

When Rs.80 was the present rate of a preference share and Rs.5 was the annual dividend, what’s the yield on the Preference Shares? 

i = D/V = 5/80 = 6.25%


Preference Shares Redemption 

Redemption for preference shares implies the repayment to preferential shareholders of a preference share capital at either a fixed date or within an amount of time, during most of the life of the given company.

According to Section 100 of a Law on Firms 1956, a company shall not, without the permission of a Court, be permitted to pay back the money from its shareholders.

In addition to a particular procedure, the court requires reimbursement of money to shareholders on capital account, whereas, the company has been in existence.

However, Section 80 of a Companies Act permits a company to issue preferential shares approved under articles of the company, only when they meet the specified requirements.


Preference Shares Taxation

It is imposed through governments of obligatory levies on individuals and entities. Taxes are levied mainly to raise income for government taken almost all over the world, though they also serve certain purposes. 

On the taxation aspect for preference shares, there is a relief to non-corporate assesses under the ‘tax indemnity clause’ throughout the Offer Document, that means if there’s any switch in tax laws ensuing to an issue, the issuer can indemnify the fund manager to an extent gains have also been impacted.


Common Stock Estimation:

The estimation of Preference Shares and Bonds showed that interest and dividend rate is reasonably fixed and regular. Bonds represent regular income flows with a finite calculable life, and preference stocks have a constant return on their shares.

The valuation of common stocks is comparatively more difficult. The difficulty comes due to two factors:

  1. The amount of dividend and timing of cash flows expected by investors are uncertain.
  2. The earnings and dividends on common shares are generally expected to grow. Valuation of shares based on dividends and earnings.

Conclusion

Thus, investors need to have full knowledge of different varieties of investments for earning huge benefits in the future.

The golden rule of investment is just invested in the share when its prices are low and let them sell out at the time when the prices are high. Though it is a suggestion for people seeking for good results in the long term, one should go for long term investments.

This will allow him to earn good profits, and they will fulfil the target of having good returns on their investment.

These days people opt for preference shares of good company and make huge profits.

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