What is a Preference Dividend?
A preference dividend is a payment made to holders of preference shares, which are a type of equity security in a company. These dividends are called “preference” because they have priority over dividends paid to common shareholders. This means that preference shareholders receive their dividends before any dividends can be paid to common shareholders.
Key Characteristics of Preference Dividends
- Fixed Dividend Rate: Preference dividends are typically paid at a fixed rate. This rate is usually specified when the preference shares are issued and remains constant.
- Priority in Payment: Preference shareholders receive their dividends before common shareholders. If the company does not have enough profits to pay dividends to both types of shareholders, only preference shareholders will receive their dividends.
- Cumulative vs. Non-cumulative: Preference dividends can be cumulative or non-cumulative.
- Cumulative preference shares mean that if a company skips a dividend payment, it must pay the missed dividends in the future before any dividends can be paid to common shareholders.
- Non-cumulative preference shares do not accumulate unpaid dividends. If a dividend payment is missed, the shareholder does not have the right to claim it in the future.
Importance of Preference Dividends
Preference dividends are important for both investors and companies for several reasons:
- Stable Income for Investors: Investors who hold preference shares receive a predictable and regular income from the fixed dividend payments, making these shares similar to bonds.
- Attractive to Risk-averse Investors: Because preference dividends are paid before common dividends, preference shares are considered less risky than common shares.
- Cost of Capital for Companies: For companies, issuing preference shares with a fixed dividend rate can be an effective way to raise capital without giving up voting control.
Example of Preference Dividends
Let’s consider a company, XYZ Ltd., which issues 1,000 preference shares at $100 each with an annual dividend rate of 5%.
- Fixed Dividend: Each preference shareholder receives an annual dividend of $5 per share (5% of $100).
- Priority in Payment: XYZ Ltd. must pay the $5 dividend to all preference shareholders before it can pay any dividends to common shareholders.
If XYZ Ltd. has a profitable year and decides to distribute dividends, preference shareholders will receive their $5 per share first. Only after this payment will the company consider distributing any remaining profits to common shareholders.
Practical Application
Advantages for Investors
- Reliable Income Stream: Preference dividends provide a steady and predictable income, which is appealing to retirees and other investors seeking regular income.
- Reduced Risk: Preference shares are less risky than common shares because of their priority in dividend payments and claims on assets in the event of liquidation.
Advantages for Companies
- Raising Capital: Issuing preference shares allows companies to raise capital without diluting voting control, as preference shares typically do not come with voting rights.
- Flexibility in Financial Planning: Companies can design preference shares with terms that suit their financial needs, such as setting fixed or floating dividend rates and deciding on cumulative or non-cumulative features.
Real-World Example
Consider ABC Corp., which issues 2,000 cumulative preference shares at $50 each with an annual dividend rate of 6%.
- Annual Dividend: Each preference shareholder receives $3 annually per share (6% of $50).
- Cumulative Feature: If ABC Corp. skips a dividend payment one year, it must pay the missed dividend ($3 per share) in future years before any dividends can be paid to common shareholders.
If ABC Corp. has financial difficulties and cannot pay dividends one year, the obligation to pay the missed dividends accumulates. In subsequent profitable years, ABC Corp. must pay all accumulated dividends to preference shareholders before paying any dividends to common shareholders.
Conclusion
Preference dividends are a crucial component of preference shares, offering investors a fixed and predictable income with priority over common dividends. This priority makes preference shares less risky than common shares, appealing to investors seeking stable returns. For companies, preference shares provide a flexible way to raise capital without diluting control. Understanding the nature of preference dividends, including their fixed rates, priority, and cumulative features, is essential for anyone involved in finance and investment.
By providing stable returns to investors and offering companies a strategic financing option, preference dividends play a significant role in financial markets. Whether you are an investor looking for steady income or a company seeking capital, preference shares and their dividends can be a valuable tool in your financial toolkit.