Preference shares

Preference shares, also known as preferred shares, are a type of financial security issued by companies that carry preferential rights over equity shares. These rights include:

1. Fixed Dividend: Preference shareholders are entitled to receive dividends at a fixed rate before any dividends are distributed to equity shareholders. This fixed dividend is typically expressed as a percentage of the face value of the preference shares.

2. Capital Return: In the event of the company's liquidation or winding-up, preference shareholders have a preferential right to receive their capital back before the equity shareholders. This means they have a higher claim on the company's assets in such situations.

Key characteristics of preference shares include:

• No Voting Rights: Unlike equity shareholders, preference shareholders generally do not have voting rights in the company's decision-making processes.

• Steady Income: Preference shares offer investors a steady stream of income through fixed-rate dividends, making them similar to fixed deposits in terms of providing regular returns.

• Limited Risk: Preference shareholders have a relatively lower risk compared to equity shareholders, as their dividends are paid before equity shareholders receive any returns.

• Non-Tax Deductible Dividends: The dividends paid to preference shareholders are not deductible as expenses from the company's profits, unlike interest on loans.

Types of Preference Shares

Preference shares can be categorized based on several factors:

1. Cumulative and Non-Cumulative: Cumulative preference shares allow the accumulation of unpaid dividends in case they are not paid in a given year, while non-cumulative preference shares do not accumulate unpaid dividends.

2. Participating and Non-Participating: Participating preference shares grant the right to share in the surplus profits of the company after a specified dividend rate is paid on equity shares. Non-participating preference shares do not have this right.

3. Convertible and Non-Convertible: Convertible preference shares can be converted into equity shares within a specified time frame, while non-convertible preference shares cannot be converted.

Merits of Preference Shares

• No Impact on Control: Preference shareholders do not have voting rights, so their ownership does not affect the control of equity shareholders over the company's management.

• Steady Income: Fixed-rate dividends provide a stable and predictable income to investors.

• Safety of Investment: Preference shares are considered a safer investment option compared to equity shares due to their preferential claim on assets during liquidation.

• Preferential Repayment: In case of liquidation or bankruptcy, preference shareholders have a preferential right to receive their capital back before equity shareholders.

• No Asset Charge: Issuing preference shares does not create any charge against the company's assets.

Limitations of Preference Shares

• Higher Dividend Rates: The dividend rates on preference shares are generally higher than the interest rates on debentures or loans, making them costlier for the company.

• Conditional Dividends: Dividends on preference shares are paid only when the company earns a profit. There is no assured return for investors in case of losses.

• Lower Risk, Lower Returns: Preference shares are not suitable for investors seeking higher returns and are willing to take on more risk.

• Dilution of Equity Claims: The issuance of preference shares dilutes the claims of equity shareholders over the company's assets.

• Non-Tax Deductible Dividends: Dividends paid to preference shareholders are not tax-deductible expenses for the company, unlike interest on loans.

Preference shares offer a balance between regular income and safety of investment, making them an attractive option for certain investors, particularly those who prioritize steady returns and limited risk. However, they also come with some limitations that should be carefully considered by both companies and investors.