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Preference Shares | Definition, Types, Feature, Advantage & Disadvantage

Preference Shares

Contents : 
  • Meaning & Definition of Preference Shares.
  • Features of Preference Shares.
  • Classification / Types of Preference Shares.
  • Advantages and Disadvantages of Preference Shares.
  • Differences Between Equity Shares and Preference Shares.

What do you mean by Preference Shares ? 


The parts of corporate securities are called as preference shares. It is the shares, which have preferential right to get dividend and get back the initial investment at the time of winding up of the company. Preference shareholders are eligible to get fixed rate of dividend and they do not have voting rights.

Meaning of Preference Shares 


Preference shares are those shares which carry certain priority rights in regards to the payment of dividend and return of capital and at the same time are subject to certain limitations with regard to voting rights. According to Indian Companies Act, 1956 Preference share is that part of the share capital of the company which is endowed with the following preferential rights :

i) Preference as to fixed rate of dividend.
ii) Preference as to repayment of capital in the event of the company being winding up.

Preference shareholder is entitled to receive the fixed rate of dividend out of the net profits of company prior to declaration or distribution of dividend on equity shares. The available net profits of the company are applied for paying specified rate of dividend to preference shareholders.


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What are the Characteristics and Types of Preference Shares ?

Issue of Preference Shares is a method of inducing less venturesome investors to subscribe to the capital being raised by the companies. They proved particularly popular in Britain in 19th Century when ambitious rail -road projects were undertaken. These securities were issued on less speculative basis and provided a guaranteed dividend in preference to the equity shareholders.

Characteristics of Preference Shares 


Preference share represents a particular portion of the share capital which has been endowed with certain preferences and limitations. It represents a hybrid security that takes some characteristics of equity shares and some attributes of debentures. The main characteristics of preference shares are as follows:

1) Maturity :
The company gets fixed capital from the preference shares like the equity shares and is not to repay it in case of non-redeemable preference shares. Redeemable preference shares are redeemed at the option of the company but as per terms of the issue. The company may also issue convertible preference shares. These shares are converted into equity shares after a stipulated period.

2) Claims on Income :
Preference shareholders have the preference in relation to dividend over the equity shareholders. They get fixed rate of dividend. There is no statutory obligation to pay dividend to non-cumulative preference shareholders. Even in the case of income, they cannot compel the company to pay dividends. But in the case of cumulative preference shares, it becomes obligatory to pay dividends on such shares. If the company does not have sufficient profits in any year, then the company will pay the all dividends in the year in which it has sufficient profits.

3) Claims on Assets :
The preference shareholders have prior claims on the assets of the company in comparison of equity shares in case of liquidation. But the company does not keep any asset as security with the preference shareholders. It means that the preference shareholders will be paid prior to equity shareholders, if the assets remain after paying off the debenture-holders.

4) Controlling Power :
The preference shareholders do not have any right to participate in the management of the company normally because they don't have voting rights for the appointment of directors and in other matters. But they have the right to vote under Section 87 on some specified issues which directly affect them.

5) Fixed Return :
The preference shareholders get the first preference to share the profits of a company. Their income is fixed, as a fixed rate of dividend is paid on preference shares.

6) Return of Capital :
The preference shareholders have a preferential right to get back their capital at the time of winding up of the company.

7) Fixed Dividend :
As per terms of issue and as per Articles of Association, they shall have a fixed rate of dividend. Hence, they are called fixed income securities.

8) Non-participation in Prosperity :
The preference shareholders cannot participate in the surplus profits of the company, unless they are participating in preference shares.

9) Non-participation in Management :
The preference shareholders do not have voting right and hence, they do not participate in the management of the company.

Classification / Types of Preference Shares 


1) Cumulative and Non-cumulative :
If there are no profits in one year and the arrears of dividends are to be carried forward and paid out of the profits of subsequent years, the preference shares are said to be cumulative. The shares are said to be non-cumulative if the unpaid dividend lapses. Unless otherwise stated in the Articles, all preference shares are presumed to be cumulative.

2) Redeemable and Irredeemable :
When the preference shares are redeemable or can be exchanged for money or goods at the end of the stipulated period, it is known as redeemable preference shares. Under Section 8 of the Companies Act, a company has the power to issue redeemable preference shares. But there must be an authority to issue redeemable preference shares in the articles of the company. The option of redemption lies with the company, i.e. the company may choose to pay back the holders of such shares. The act of paying back is called redemption.

Conditions for Redemption :

There are a few conditions for redemption which are as follows:
  • The shares which are to be redeemed should be fully paid up.
  • Shares shall be redeemed only out of profits or by making a fresh issue of equity shares.
  • If any premium is payable on redemption, the amount must have been provided for out of the profits of the company or out of the company's share premium account.
  • Where redemption is made out of profits, a sum equivalent to the amount paid on redemption shall be transferred to a reserve fund called the Capital Redemption Reserve Account.
Irredeemable shares are non-refundable to the shareholders during the life time of the company. But the amendment of the Companies Act in 1988 has abolished the category of irredeemable preference shares. No company shall issue preference shares redeemable after the expiry of a period of 10 years from the date of issue.

3) Convertible and Non-convertible :
Convertible preference shares are those which can be converted into equity shares within a stipulated period of time. The terms of issue may provide such a right to preference shares. These shares may be given an option after five years to convert into ordinary shares at a certain conversion rate. The preference shares which are not convertible into equity shares are called non-convertible preference shares.

4) Participating and Non-participating :
In spite of having a fixed rate of dividend, the participating preference shareholders share in the surplus of the company. They have two dividends. One is fixed by the articles and the other would be fluctuating according to the size of surplus profits left after paying a certain dividend on ordinary shares. Non-participating preference shares are nothing but ordinary preference shares which carry only the fixed rate of dividend.

Advantages of Preference Shares 


Preference shares are hybrid financing instruments having several benefits for using them as a source of capital. Benefits are in the form of absence of legal obligation to pay dividend, improves borrowing capacity, and saves dilution in control of existing shareholders and no charge on assets.

1) Fixed Dividend :
The dividend rate is fixed in the case of preference shares. It is called as fixed income security because it provides a constant rate of income to the investors.

2) Cumulative Dividends :
Preference shares have another advantage which is called cumulative dividends. If the company does not earn any profit in any previous years, it can be cumulative with future period dividend.

3) Redemption :
Preference Shares can be redeemable after a specific period except in the case of irredeemable preference shares. There is a fixed maturity period for repayment of the initial investment.

4) Participation :
Participative preference shareholders can participate in the surplus profit after distribution to the equity shareholders.

5) Convertibility :
Convertibility preference shares can be converted into equity shares when the articles of association provide such conversion.

6) Economical :
Comparing to equity shares, financing preference shares is less costly, so they can be issued for meeting heavy capital expenditure.

7) Enabling Reconstruction and Reorganization :
Whenever a company is reorganized (or) reconstructed, the board with the consent of the creditors can easily convert the debts into preference shares.

8) Increasing the marketability :
The preference shares can be utilized for raising the value of the equity shares and debentures in the open market. Everyone who purchase certain number of equity shares may be provided with certain number of preference shares as bonus.

Disadvantages of Preference Shares 


The credit worthiness of the company may be affected by existence of preference shares. Following are the disadvantages of preference shares:

1) Expensive Sources of Finance :
Preference shares have high expensive source of finance while compared to equity shares.

2) No Voting Right :
Generally preference shareholders do not have any voting rights. Hence they cannot have the control over the management of the company.

3) Fixed Dividend Only :
Preference shares can get only fixed rate of dividend. They may not enjoy more profits of the company.

4) Permanent Burden :
Cumulative preference shares become a permanent burden so far as the payment of dividend is concerned, because the company must pay the dividend for the unprofitable periods also.

5) Taxation :
In the taxation point of view, preference shares dividend is not a deductible expense while calculating tax. But, interest is a deductible expense. Hence, it has disadvantage on the tax deduction point of view.

Difference between Equity Shares and Preference Shares 


Basis

Equity Shares

Preference Shares

Right to get the Dividend

Entitled to get the dividend only after the company has distributable surplus profits after paying out the dividend to preference. shares, if any.

Get a preference as to the payment of dividend.

 

Rate of dividend

 

Rate of dividend for equity share varies from year to year.

Get the dividend at a certain rate, fixed at the time of issue.

 

Right of voting

 

Equity share holders always have to right of voting.

Can be converted after a certain rate. If so provided at certain period.

Risk

 

These are subject to the maximum risk as to the payment of dividend also as well as to the return of capital.

It is not necessary for any company to issue these. These bear the risk second to equity shares.

 

Accumulation of dividend

 

Never entitled to a cumulative dividend.

 

Entitled to get the accumulative dividend, if the shares are so issued.

Redemption in the life of company

A company can never redeem.

 

Get a preference to get the refund of capital over equity shares.

Convertibility 

 

Cannot be converted.

 

These can be redeemed during the life of the company also they are redeemable.

Right to get their fund of capital

Get the refund of their amount only at last.

 

Get a preference to get the accumulative dividend, if the shares are so issued.

Compulsion

 

A company with shares capital must issue these.

Shareholders can vote only in the exceptional cases.


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