In the complex world of corporate finance, the concept of preference share capital plays a significant role in capital structuring and investment decisions. As businesses look for ways to raise capital, they often turn to equity financing. Among the different types of equity, preference shares stand out for their unique features and the preferential treatment they receive compared to ordinary shares. In this article, I will provide a deep dive into priority equity, focusing on preference share capital, its characteristics, its advantages and disadvantages, and how it fits into the broader framework of a company’s capital structure. I will also explore real-world examples, provide relevant calculations, and explain how preference shares function in practice. Additionally, I will discuss the impact of preference shares on the financial health of a company, investors’ returns, and the overall corporate strategy.
Table of Contents
What are Preference Shares?
Preference shares, also known as preferred stock, represent a class of equity that typically provides shareholders with a fixed dividend before any dividends are paid to common shareholders. These shares have priority over common shares in the event of liquidation, but they generally do not carry voting rights. Preference shares can be an attractive option for investors seeking stable income through dividends, as well as for companies aiming to raise capital without diluting control.
The key feature of preference shares is the priority of dividend payments and liquidation rights over common equity. However, preference shareholders usually do not have voting rights, which distinguishes them from common shareholders who can vote on corporate matters such as the election of directors.
Types of Preference Shares
Not all preference shares are the same. There are various categories of preference shares, each with its own set of rights and obligations. Some of the common types include:
- Cumulative Preference Shares: These shares accumulate unpaid dividends. If a company fails to pay dividends in a given year, the unpaid dividends will carry over to the next year, and the company must pay these accumulated dividends before any dividends can be paid to common shareholders.
- Non-Cumulative Preference Shares: These shares do not accumulate unpaid dividends. If a company skips a dividend payment, preference shareholders have no right to claim the missed dividend in the future.
- Convertible Preference Shares: These shares can be converted into common shares at a predetermined ratio or price, typically after a certain period. This feature allows shareholders to participate in the potential upside of the company’s equity if it performs well.
- Redeemable Preference Shares: These shares can be redeemed or bought back by the company at a predetermined price and date. This gives the company the flexibility to repurchase the shares at a later time, which can be advantageous in managing capital structure.
- Participating Preference Shares: These shares not only provide a fixed dividend but also allow the shareholder to participate in additional profits beyond the fixed dividend. If the company performs exceptionally well, participating preference shareholders can receive extra dividends.
Table 1: Types of Preference Shares
| Type | Key Feature | Advantage | Disadvantage |
|---|---|---|---|
| Cumulative Preference Shares | Dividends accumulate if unpaid | Ensures payment of dividends in the future | Can lead to large accumulated dividends |
| Non-Cumulative Preference Shares | No accumulation of unpaid dividends | Simpler and more predictable dividend payments | Missed dividends are lost |
| Convertible Preference Shares | Can be converted into common shares | Opportunity to convert to equity if company performs well | Potential dilution of existing equity |
| Redeemable Preference Shares | Can be bought back by the company | Company can manage capital structure flexibly | May limit investors’ potential upside |
| Participating Preference Shares | Fixed dividend plus extra profit sharing | Potential for higher returns if the company performs well | More complex dividend distribution |
Why Do Companies Issue Preference Shares?
Companies issue preference shares for several reasons, primarily to raise capital without taking on debt. While issuing common shares can dilute the ownership of existing shareholders, issuing preference shares allows the company to raise funds while offering preferential treatment to investors. Below are some of the main reasons companies choose to issue preference shares:
- Capital Raising Without Dilution of Control: Preference shares do not carry voting rights, meaning that the company can raise funds without giving up control to new investors. This is particularly important for companies seeking to maintain a stable ownership structure.
- Stable Dividend Payments: Unlike common shares, which may or may not pay dividends, preference shares typically provide a fixed dividend. This makes preference shares attractive to investors who seek predictable returns.
- Flexibility in Capital Structure: Preference shares provide companies with flexibility in managing their capital structure. By issuing preference shares, a company can obtain equity financing without increasing debt levels, which can be particularly important for companies looking to maintain a strong balance sheet.
- Attractive to Certain Investors: Preference shares appeal to conservative investors who are primarily interested in stable income rather than capital appreciation. These investors are typically risk-averse and prefer the relative safety and predictability of fixed dividend payments.
- Avoidance of Debt Covenants: When a company issues debt, it may be required to adhere to various covenants, such as maintaining certain financial ratios. By issuing preference shares, companies can raise capital without being subject to such covenants.
How Preference Shares Fit Into the Capital Structure
To understand the role of preference shares in a company’s capital structure, it is important to consider the broader context of a company’s financing. A typical corporate capital structure consists of three main components:
- Equity Capital: This is the ownership capital of a company, represented by common shares and preference shares. Equity capital carries no fixed obligation to repay and represents the residual value of the company after all liabilities have been paid.
- Debt Capital: Debt capital refers to borrowed funds that a company must repay, often with interest. Debt is typically senior to equity in terms of repayment priority in the event of liquidation.
- Hybrid Capital: Preference shares fall into the category of hybrid capital, as they possess characteristics of both equity and debt. They provide a fixed dividend (like debt) but do not represent ownership in the same way as common shares (equity).
Preference shares, therefore, sit between debt and equity in the capital structure, providing a middle ground between the two. They are typically seen as a more stable form of financing than common equity but less risky than debt, as they do not require repayment of principal.
Table 2: Capital Structure Breakdown
| Type of Capital | Priority in Liquidation | Cost of Capital | Ownership Rights |
|---|---|---|---|
| Debt Capital | High (senior to equity) | Generally lower (interest) | None |
| Preference Shares | Medium (after debt) | Fixed (dividend) | No voting rights |
| Common Equity Capital | Low (residual claim) | Higher (dividends depend on profits) | Full ownership rights |
Calculating the Cost of Preference Share Capital
One of the important factors to consider when dealing with preference shares is the cost of preference share capital. This is the return that a company must provide to its preference shareholders in the form of dividends. The cost of preference share capital can be calculated using the following formula:
Where:
- Preferred Dividend is the fixed dividend paid to preference shareholders.
- Net Issue Price is the price at which the preference shares were issued, after deducting issuance costs.
Example Calculation:
Let’s assume a company issues preference shares with a face value of $100 per share, and the dividend rate is 8%. If the company sells the shares for $95 each (after deducting issuance costs), the cost of preference share capital would be calculated as follows:
In this example, the company’s cost of preference share capital is 8.42%, meaning it must pay 8.42% of the issue price annually to its preference shareholders.
Advantages and Disadvantages of Preference Shares
Like any financial instrument, preference shares come with their own set of advantages and disadvantages for both companies and investors.
Advantages for Companies:
- Non-Dilutive Financing: Unlike common equity, preference shares do not dilute control since they typically do not carry voting rights.
- Lower Cost of Capital: Compared to issuing debt, preference shares may be a cheaper source of financing, especially for companies with limited access to debt markets.
- Flexibility in Dividend Payments: Companies may have the option to defer dividend payments on non-cumulative preference shares without facing legal repercussions.
Disadvantages for Companies:
- Fixed Dividend Obligations: Companies must pay dividends to preference shareholders before paying any dividends to common shareholders, even if the company is not performing well.
- Limited Upside for Investors: While preference shareholders receive fixed dividends, they do not benefit from the company’s capital appreciation as common shareholders do.
- Redemption Risk: If the company is required to redeem preference shares, it may face significant cash outflows, which can affect its liquidity.
Advantages for Investors:
- Stable Income: Preference shares provide a fixed income stream, which can be attractive to income-focused investors.
- Priority in Liquidation: In the event of bankruptcy, preference shareholders are paid before common shareholders.
- Conversion Option: In the case of convertible preference shares, investors have the potential to convert their shares into common stock, which could increase their return if the company’s stock price rises.
Disadvantages for Investors:
- No Voting Rights: Preference shareholders typically do not have a say in the company’s decision-making process.
- Limited Upside: The potential for capital appreciation is limited since preference shares generally do not participate in the company’s growth beyond the fixed dividend.
- Dividend Suspension: In some cases, companies may suspend dividend payments on preference shares, especially in financial distress.
Conclusion
Preference share capital plays a crucial role in corporate finance, offering companies a way to raise funds without diluting control or taking on debt. For investors, preference shares provide a relatively stable income stream with priority in liquidation, making them an attractive option for conservative investors seeking predictable returns. However, preference shares come with their own set of risks, including limited upside potential and the possibility of dividend suspensions. By understanding the nuances of preference shares, companies and investors can make informed decisions that align with their financial goals and risk tolerance.
