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Before getting into the concept of preference shares, it is crucial to understand the meaning of dividends. A Dividend can be defined as the profit that a company pays out to its shareholders. Dividends are distributed on a regular basis. They are a great way for investors to earn money. But, not all stocks pay dividends. Preference shares are a special type of shares that receive dividends preferentially over common equity shares. With preference shares, the shareholders can also choose to claim the payback of capital, if the company ever gets shut down. Preference shares include the features of both equity and debt instruments. Preference stockholders, however, do not have any voting rights in the company as equity shareholders do.
Preference Shares Features
As already discussed above, the main feature of preference shares is that they get preference as to payments being made by way of dividends that are announced by the company. If a company decides to pay dividends to shareholders, they would first be paid to preference shareholders. In a similar way, if a company winds up its business, it would first repay the capital to preference shareholders.
In this investment option, the investor gets a fixed dividend amount, regardless of the total profit earned by the company. This makes them similar to debt investments as a fixed rate of dividend is paid out annually. It makes these shares ideal for those investors who want to minimise their risk.
The biggest drawback of preference shares is that these shareholders have no rights when it comes to the voting process in the company. The second drawback is incurred by companies in the form of a higher issuing cost associated with preference shares as compared to debt.
Types of Preference Shares
There are broadly four types of preference shares that would be discussed here. They are described as follows:
- Cumulative preference shares: If an investor chooses to invest in cumulative preference shares, then they will get all dividends, including the ones that were not paid by the company previously. In short, the company has to pay cumulative preference shareholders their due dividends before paying them out to common stockholders. Many times, when the company is paying dividends at a later date, it pays extra interest to the investors.
- Non-cumulative preference shares: In this case, if the company omits to pay dividends in a particular cycle due to insufficient funds, then the shareholders can not claim the payment at a later date. A company can very well choose to omit to pay dividends. These shares, hence, do not always guarantee dividend payments. Non-cumulative shares are less expensive than cumulative preference shares.
- Participating preference shares: In these preference shares, the investors can get dividends as a sum of specified dividends at a fixed interest rate and an additional dividend. The additional dividend is paid when the dividend amount paid to common stockholders is higher than the predecided per-share amount. In case the company decides to liquidate itself, these investors have a right to claim not just the purchasing price of the stock but also a pro-rata share of other proceeds which are paid out to stockholders.
- Convertible preference shares: Using this option, preference shares can be converted to common equity shares. This right can be claimed after a predetermined period of time at a specified exercise price.
Benefits to the Company
Since the preference shareholders do not have any voting rights, it gives more power to the company to make important company decisions. The company has more control over its functioning.
In case the company issues callable preference stocks, it also has the option to buy back the shares when they want to. This is usually advantageous in case the interest rates fall down. For example, if the callable preference shares are issued at a specified dividend of 8% but the interest rate plunges down to 6%. In such a case, the company can buy outstanding shares at the current market price and then issue them at a lower dividend rate. This way the company can reduce its cost of capital. However, this is not the best situation for investors as their profit making potential can decrease.
Difference Between Equity and Preference Share
Equity shares | Preference shares |
The dividend rate is varied and depends upon the earnings of the company. | Preference shares include a fixed rate of dividend. |
In the case of capital repayment, the payment is made in the end. | Preference shareholders are paid in the beginning when the company liquidates. |
They cannot be converted to any other mode of investment. | They can be converted to equity shares. |
Not eligible for receiving arrears of dividend | Can receive arrears of dividend |
They are better for investors with a higher risk threshold | They are better for risk-averse investors. |
High liquidity | Low liquidity |
Conclusion
Preference shares are a form of investment in which the investors are eligible for preferential payment of dividends, i.e., they receive dividends before the common shareholders. It is a hybrid investment mode, which is considered a mix of debt and equity. It is because it offers dividends at a fixed rate. Because of this, it is best suited for investors with a lower risk appetite, who want to earn good returns on their investment. They are considered ideal tools of investment for the medium-term or long-term.
