In the realm of corporate finance, understanding preference shares—also known as preference equity—is essential for anyone seeking to make informed investment decisions or manage a company’s capital structure effectively. Preference shares represent a class of equity with unique rights and privileges compared to common shares. These rights often include priority over common shareholders in receiving dividends and in the event of liquidation. In this article, I will explore the nature of preference shares, their different types, how they fit into a company’s capital structure, and the advantages and disadvantages for both companies and investors. Additionally, I will provide examples, mathematical calculations, and illustrations to help clarify the key concepts related to preference shares.
Table of Contents
What Are Preference Shares?
Preference shares are a class of equity that generally gives shareholders a fixed dividend and priority over common shareholders in terms of dividend payments and asset distribution in the event of liquidation. However, preference shares typically do not come with voting rights, making them distinct from common shares.
The primary characteristic of preference shares is the fixed dividend, which is paid before any dividends are distributed to common shareholders. This makes them an attractive option for income-seeking investors. Furthermore, in the event of a company’s liquidation, preference shareholders are given priority over common shareholders, though they still rank below debt holders.
While preference shares are technically equity, they have features that make them similar to debt instruments, particularly in the way they provide predictable income streams through fixed dividends. These features make preference shares a hybrid form of financing, combining the characteristics of both debt and equity.
Types of Preference Shares
Not all preference shares are identical. There are several types of preference shares, each with different features and conditions. These differences impact both the issuer (the company) and the investor. Below are some common types of preference shares:
1. Cumulative Preference Shares
Cumulative preference shares allow shareholders to accumulate unpaid dividends. If a company misses a dividend payment in a given year, the missed dividend is carried forward and must be paid before any dividends can be paid to common shareholders. This is one of the most common forms of preference shares because it protects the interests of investors by ensuring they eventually receive their dividends, even if the company faces financial difficulties in a particular year.
2. Non-Cumulative Preference Shares
Non-cumulative preference shares, in contrast, do not allow the accumulation of missed dividends. If a company skips a dividend payment, the preference shareholder loses that payment and has no right to claim it in future periods. This type of preference share is less favorable to investors compared to cumulative preference shares but can still offer a fixed income stream.
3. Convertible Preference Shares
Convertible preference shares give the shareholder the right to convert the preferred stock into common stock at a predetermined ratio or price. This feature provides potential upside for the investor if the company’s common stock appreciates in value. For the company, convertible preference shares can be an attractive way to raise capital, as they allow for the possibility of future dilution if investors choose to convert their shares.
4. Redeemable Preference Shares
Redeemable preference shares are those that the company can buy back at a predetermined price and date. This allows the company to manage its capital structure by repurchasing shares when needed, which can help reduce the number of outstanding preference shares and lower the dividend burden over time.
5. Participating Preference Shares
Participating preference shares offer shareholders not only a fixed dividend but also a right to participate in any additional profits the company may generate. If the company performs exceptionally well, participating preference shareholders can receive additional dividends beyond their fixed dividend. This feature makes participating preference shares more appealing to investors compared to non-participating preference shares.
Table 1: Types of Preference Shares
| Type | Key Feature | Advantage | Disadvantage |
|---|---|---|---|
| Cumulative Preference Shares | Unpaid dividends accumulate | Ensures eventual dividend payments | Accumulating unpaid dividends may burden company |
| Non-Cumulative Preference Shares | No accumulation of unpaid dividends | Simpler, no long-term dividend burden | Missed dividends cannot be claimed later |
| Convertible Preference Shares | Can be converted into common stock | Potential upside if stock price increases | Potential dilution of existing common shareholders |
| Redeemable Preference Shares | Can be bought back by the company | Flexibility for the company to repurchase shares | Investors may not benefit from long-term appreciation |
| Participating Preference Shares | Fixed dividend + participation in additional profits | Potential for higher dividends if company performs well | More complex dividend distribution process |
Why Do Companies Issue Preference Shares?
Companies issue preference shares for several key reasons, often to strike a balance between raising capital and managing their capital structure. The main reasons for issuing preference shares include:
- Raising Capital Without Diluting Control: Issuing preference shares allows a company to raise capital without giving up control, as preference shares typically do not carry voting rights. This is particularly important for companies that wish to avoid dilution of control among existing shareholders.
- Attractive to Certain Investors: Preference shares appeal to income-focused investors because they provide a fixed dividend, offering predictable income. Additionally, preference shares are typically less risky than common shares, making them a suitable investment for conservative investors.
- Less Risky Than Debt: Preference shares provide a more flexible financing option than debt. Unlike debt financing, there is no legal obligation to make fixed interest payments, which can alleviate pressure on the company during difficult financial periods. While the dividends are generally fixed, the company has more flexibility compared to debt obligations, which often come with restrictive covenants.
- Priority Over Common Shares: In the event of liquidation, preference shareholders are paid before common shareholders. This priority makes preference shares attractive to investors seeking more security than common equity offers, especially when the company faces financial difficulties.
- Hybrid Capital: Preference shares serve as hybrid capital, blending the characteristics of debt and equity. They provide a steady income stream, similar to debt, while also offering the potential for upside through equity-like features such as convertibility or participation.
How Preference Shares Fit Into the Capital Structure
A company’s capital structure consists of debt and equity, and preference shares represent a hybrid form that straddles both categories. Understanding how preference shares fit into the broader capital structure helps to see why companies use them.
In a typical capital structure, the order of claims in the event of liquidation is as follows:
- Debt Holders: Creditors are the first to be paid in the event of liquidation. Debt holders have seniority over all other claimants, meaning they are entitled to repayment of principal and interest before any payments are made to equity holders.
- Preference Shareholders: After debt holders, preference shareholders are next in line. They receive their fixed dividend before any payments are made to common shareholders. In the event of liquidation, preference shareholders are paid from the remaining assets before common shareholders.
- Common Shareholders: Common shareholders are the last to be paid. They only receive payment after all debts and preference shareholders have been paid. In the event of liquidation, common shareholders may not receive any payment if the company’s assets are insufficient.
The capital structure can be represented by the following hierarchy:
Table 2: Capital Structure Priority
| Type of Capital | Priority in Liquidation | Dividend Payment | Risk Level |
|---|---|---|---|
| Debt Capital | First (most senior) | Fixed (interest) | Low |
| Preference Shares | Second (after debt) | Fixed (dividends) | Medium |
| Common Shares | Last (residual claim) | Variable (if any) | High |
Preference shares are therefore positioned between debt and common equity, offering a unique blend of security and potential returns. For the company, this structure provides flexibility in managing capital while maintaining a relatively stable cost of capital.
Calculating the Cost of Preference Share Capital
A key consideration when issuing preference shares is the cost of preference share capital, which is the return a company must pay to its preference shareholders in the form of dividends. This cost can be calculated using the following formula:
\text{Cost of Preference Share Capital} = \frac{\text{Preferred Dividend}}{\text{Net Issue Price}} \times 100Where:
- 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 say a company issues preference shares with a face value of $100 per share, offering an 8% annual dividend. The shares are issued at a price of $95, after deducting issuance costs. The cost of preference share capital would be calculated as follows:
\text{Cost of Preference Share Capital} = \frac{8}{95} \times 100 = 8.42%In this case, the company’s cost of preference share capital is 8.42%, which represents the annual dividend yield relative to the issue price of the preference shares.
Advantages and Disadvantages of Preference Shares
Like any financial instrument, preference shares come with both advantages and disadvantages, depending on the perspective of the issuer and the investor.
Advantages for Companies:
- Non-Dilutive Financing: Preference shares do not dilute control since they generally do not carry voting rights.
- Flexible Dividend Payments: Preference shares provide a predictable dividend stream, but the company may have more flexibility compared to debt financing.
- Attractive to Certain Investors: Preference shares offer a stable income stream, making them appealing to conservative investors.
Disadvantages for Companies:
- Fixed Dividend Payments: Companies are obligated to pay dividends to preference shareholders before paying dividends to common shareholders.
- Limited Upside for Investors: Preference shareholders do not benefit from the company’s capital appreciation in the same way common shareholders do.
- Redemption Risk: Companies may need to repurchase preference shares, which can involve significant outflows of cash.
Advantages for Investors:
- Stable Income: Preference shares provide a fixed income stream, making them attractive to income-focused investors.
- Priority in Liquidation: Preference shareholders are paid before common shareholders in the event of liquidation.
- Convertible Features: Convertible preference shares provide the opportunity for upside if the company’s stock price increases.
Disadvantages for Investors:
- No Voting Rights: Preference shareholders typically do not have a say in company decisions.
- Limited Capital Appreciation: Preference shareholders do not share in the company’s growth beyond their fixed dividend.
- Dividend Suspension: In some cases, the company may suspend dividend payments on preference shares.
Conclusion
Preference shares play an important role in the capital structure of a company, offering a unique form of financing that blends elements of both debt and equity. For companies, preference shares provide a way to raise capital without diluting control or taking on debt
