What is Preference Share?

Ever wanted to be a shareholder with special benefits and claim over the assets of the company upon probable liquidation? Then, preference shares are the right choice. Investing in preference shares ensures that the shareholders are given priority over the common shareholders and receive a fixed dividend.

In addition, people can earn way more from these priority shares, potentially making it a passive income. So, read through the article to get insights on the types of preference shares, their features, advantages and disadvantages, and more.

What are Preference Shares?

Preference shares are the priority shares that provide extra benefits to the shareholders over the common shareholders of the company. Preference shares ensure that its shareholder gets the first dividend payout from the company at a fixed time and price.

In addition, there are many types of preference shares, each with its unique benefit. For instance, certain shares promise a dividend payout based on the market interest rates. In contrast, certain others have a cumulative feature where the dividend, if not paid, gets accumulated and paid in the upcoming cycle.

What are the Types of Preference Shares?

Preference shares can be an interesting and advantageous investment for shareholders. Here are the various types of preference shares you should keep in mind:

1. Cumulative Preference Shares

Cumulative preference shares are the type of preference shares wherein the shareholders are entitled to dividend payouts no matter if the company is making profits or not. In case the company does not make any profit in the financial year, the dividends will be added up and paid in the following year upon making profits.

2. Non-Cumulative Preference Shares

Unlike cumulative shares, non-cumulative preference shares are the types where the company is the sole judge of handing out the dividends to the shareholders. It is not bound to pay the pending dividends, and the shareholders do not hold any right to the dividends under this type of share.

3. Redeemable Preference Shares

Redeemable preference shares allow companies to redeem them in the future. As a general rule, though, the companies are supposed to redeem these shares within about 20 days from the date of issuing. These types of shares are also called callable preference shares since the company holds the right to redeem them.

4. Irredeemable Preference Shares

This type of preference share allows the company to redeem the shares only when the operations have been shut down or upon the liquidation of assets. Unlike the redeemable preference shares, the company cannot redeem the shares at will. Currently, Indian companies are not allowed to issue these preference shares.

5. Participating Preference Shares

Participating in preference shares allows the shareholder special rights to earn more than just the fixed shares whenever the company makes profits. They can get higher dividends than the shareholders of normal shares if the company makes a surplus profit and decides to pay out dividends.

6. Non-Participating Preference Shares

Unlike the participating preference shares, the non-participating preference shares do not allow any right to the shareholder to have higher dividends than the standard when the company makes a surplus profit. People earn the standard dividend and cannot participate in the company's surplus earnings.

7. Convertible Preference Shares

Convertible preference shares are transformed into equity shares of the company later at a particular time as per the terms and conditions of the company. This type of preference share gets the shareholders a fixed return by dividends and even promises higher returns in case the share price of the shares of the company rises.

8. Non-Convertible Preference Shares

Non-convertible preference shares cannot be transformed into the company's equity shares. However, these preference shares give the shareholders special rights to the payout of capital if the company shuts down, which is not guaranteed in the common shares of the company.

9. Adjustable Rate Preference Shares

Adjustable-rate preference shares, just like its namesake, do not have any fixed dividends if the company makes a profit. The dividends are generally paid depending on the market interest rates. In this way, the shareholders sometimes make a better profit than they would if they had common shares.

10. Callable Preference Shares

The callable preference shares are the shares that the company has special rights to buy back or redeem at times as per the guidelines. The company may call back the shares at a certain price on a certain date, abiding by the predetermined guidelines of the financial market.

What are the Features of Preference Shares?

Preference shares possess a better claim than just common shares, but that is not all. Here are the various features of the preference shares to keep in mind:

1. Priority

Upon liquidation of the company’s assets, the holders of the preference shares are prioritised to get the claim compared to the common shareholders. So, if the company's operations shut down, one of the first people to benefit from the situation and redeem their claims would be the holders of preference shares.

2. Dividends

Preference shares are senior to common shares given out to the investors by the company. Hence, whenever the dividends are paid, the preference shareholders get the payments first and, in some cases, even have the chance to earn more than the common shareholders would do.

3. Voting

In the company's decisions, not all the shareholders have voting rights, and the common shareholders do not have such rights. However, with certain preference shares, the company may provide voting rights to the shareholders regarding specific events. Even though it is possible, it is rare.

4. Convertible

Certain types of preference shares can be converted to common equity, giving the shareholders of these shares an upper hand over the holders of common shares. In general, the convertibility of such shares either has a specific conversion date or requires approval from the company’s board of directors.

5.  Callability

Certain preference shares can be called back or redeemed by the company at particular dates. If the company decides to do so, it can buy back the preferred shares at the specific date and price specified by the financial market guidelines.

6. Adjustability

Some preference shares have the feature of being adjustable, which allows the shareholders of such shares the option to earn dividends according to the interest rate prevailing in the market and not rely on fixed rates by the company. Hence, sometimes, the shareholders have a chance to earn more than the general.

What are The Advantages of Preference Shares?

Preference shares are a wonderful investment, sometimes even ranked higher than common shares to buy. Here are the advantages of preference shares to consider:

1. Security

Those with preference shares have a certain kind of security compared to those with common shares. This is especially seen in the case of the liquidation of the company when the shareholders of the preference shares have a rightful claim over the assets while the common shareholders do not.

2. Fixed Income

Preference shares ensure that the shareholder gets a continual dividend from the company. Even if the company is not making profits, the dividends get accumulated and paid in the next financial year. So, the people holding such shares can have a worry-free passive income.

3. Cumulative Dividends

As for the company, if it is not making any profit, it can choose not to pay the dividends to the reference shareholders and instead add it to the next financial cycle when it makes surplus profit. This keeps the company burden-free and functioning well, preventing it from having to give out losses.

4. Flexibility

The preference shares are set up by the company's board of directors, who bear full rights to set up the preference shares as needed. They can also choose to dilute the preference shares as they see fit for the company and its functioning.

5. Low Risk

Since the preference shares promise a constant or at least a cumulative dividend, the shareholders can enjoy a risk-free passive income. Also, it gives the shareholders of such shares priority in claiming assets upon the liquidation of the company. So, it is a low-risk investment.

What are the Disadvantages of Preference Shares?

Although preference shares are an attractive investment, they are not free of drawbacks. Here are the disadvantages of the preference shares:

1. Limited Voting Rights

Like most company shareholders, preference shareholders do not often get an opinion heard about the company’s operations. They do not have a say in the inner workings and do not get voting rights.

2. Fixed returns

Unless the type of preference share is adjustable to the market interest rate, investors only get a fixed amount of return no matter how big the company's profit is. This somehow limits the potential to earn more from the share.

3. Call Risk

Call risk can be the most disadvantageous of all. Here, the company can call back or buy back the preference shares on a certain date and price if the situation asks for it. However, in most cases, there are guidelines for when the company can call back the shares.

4. Inflation Risk

Preference shares have inflation risk since the shareholders only earn a fixed amount. So, even when inflation runs high, the amount earned remains the same, which lowers the actual value of the income earned through the dividends over some time.

Cost of Preference Shares

Typically, the cost of preference shares is determined by the dividend rate and the prevailing market conditions at the time of issuance. This cost represents the effective rate of return that the company must provide to preference shareholders.

The cost of preference shares is often compared to the cost of debt financing, as both represent fixed obligations for the company. However, unlike debt, preference share dividends are not tax-deductible for the issuing company, making them relatively more expensive.

The formula to calculate the cost of preference shares is:

Cost of Preference Shares = (Annual Dividend per Preference Share) / (Net Proceeds from Issuance per Preference Share)

Example: If a company issues preference shares with a face value of ₹100 each, offering a dividend rate of 10%, and the net proceeds from the issuance are ₹95 per share (after deducting issuance costs), the cost of preference shares would be:

Cost of Preference Shares = (₹10 Annual Dividend) / (₹95 Net Proceeds) = 10.53%

It's important to note that the cost of preference shares may vary depending on factors such as the company's creditworthiness, market conditions, and the specific terms and features of the preference shares being issued.

Investing in Preference Shares: Tips for Success

• Align with your goals: Consider your risk tolerance and desired income stream.
• Research the company: Evaluate financial health, credit ratings, and dividend history.
• Understand the terms:  Review dividend rates, call/conversion features, and redemption periods.
• Diversify your portfolio: Invest in preference shares across different sectors and companies.
• Monitor performance: Stay updated on the company's performance and market conditions.
• Seek professional advice: Consider consulting a financial advisor for personalized guidance.

The Key Takeaway

Preference shares are priority shares that benefit the shareholders in many ways. From getting a stable passive income to having a claim over the company's assets upon its liquidation, the preference shares bring a lot of advantages to the shareholders and, in some cases, the company.

Although the downsides, such as the inflation risks, do prevail, it is, nonetheless, a great investment to make when wanting a fixed dividend income. So, preference shares are among the best assets for shareholders.

Additionally, if you need information related to the stock market, you must visit Choice Blog to get information about the stock market.

FAQs

1. Are preference shares low-risk investments?

Yes, the preference shares are low-risk investments since the shareholders are promised a fixed dividend every financial year, regardless of company condition. Besides, upon probable liquidation, these shareholders have the right to claim the assets.

2. Can preference shares be called back?

Yes, unfortunately, if the company decides to redeem or call back the preference shares, it can. However, there are certain guidelines that the company has to follow and a stipulated time for when they have to call back the shares.

3. Do the preference shareholders have voting rights in the company?

Generally, the preference shareholders do not have voting rights in the company. On rare occasions, however, the company may decide to involve the preferred shareholders over the common shareholders in limited voting.

4. Do preference shares promise dividends even when the company is not at a profit?

Yes, the preference shareholders get dividends even when the company is not making a profit. However, they might get the cumulative payment in the financial year when the company can provide the payment.

5. Can the preference shareholders claim certain company assets upon liquidation?

Yes, one of the major advantages of being a preference shareholder is having the right to claim certain types of company assets and securities upon liquidation. This is not provided to common shareholders.