As a finance student, I often encounter questions about the different types of capital a company can raise. One of the most intriguing yet misunderstood instruments is preference share capital. Unlike common equity, preference shares blend characteristics of both debt and equity, making them a unique financing tool. In this guide, I will break down the mechanics, advantages, disadvantages, and real-world applications of preference shares, ensuring you grasp the concept thoroughly.
Table of Contents
What Are Preference Shares?
Preference shares, also known as preferred stock, represent a class of ownership in a company that has a higher claim on assets and earnings than common stock. Holders of preference shares typically receive fixed dividends before any dividends are paid to common shareholders. If the company liquidates, preferred shareholders have priority over common shareholders in asset distribution.
Key Features of Preference Shares
- Fixed Dividends – Preference shareholders receive dividends at a predetermined rate, similar to bond interest payments.
- Priority in Liquidation – In case of bankruptcy, preferred shareholders rank above common shareholders but below debt holders.
- Limited Voting Rights – Unlike common shareholders, preferred shareholders usually do not have voting rights unless specified.
- Convertibility – Some preference shares can be converted into common stock at a predetermined ratio.
Types of Preference Shares
Understanding the different types of preference shares helps in analyzing their role in corporate finance. Below is a comparison table:
| Type | Description | Example |
|---|---|---|
| Cumulative | Unpaid dividends accumulate and must be paid before common dividends. | If a company skips dividends in Year 1, it must pay them in Year 2. |
| Non-Cumulative | Dividends do not accumulate if skipped. | Missed dividends in Year 1 do not carry forward. |
| Convertible | Can be converted into common shares at a preset ratio. | 1 preference share = 5 common shares after 3 years. |
| Redeemable | The company can buy back shares at a fixed price after a certain date. | Shares redeemable at \$25 per share after 5 years. |
| Participating | Shareholders receive extra dividends if company profits exceed a threshold. | If profits exceed \$10M, preferred shareholders get a bonus. |
| Adjustable-Rate | Dividend rate fluctuates based on a benchmark interest rate. | Dividend = Treasury yield + 2%. |
Why Companies Issue Preference Shares
From a corporate perspective, preference shares offer several strategic benefits:
- Flexibility in Dividend Payments – Unlike bonds, companies can defer dividends on non-cumulative preference shares without default risk.
- No Dilution of Control – Since preferred shareholders usually lack voting rights, existing management retains control.
- Hybrid Financing Tool – Preference shares improve the debt-to-equity ratio since they are treated as equity on the balance sheet.
However, issuing preference shares is not without drawbacks. The fixed dividend obligation can strain cash flows, and if the shares are cumulative, unpaid dividends pile up as liabilities.
Valuation of Preference Shares
Valuing preference shares involves calculating the present value of expected future dividends. Since preferred dividends are typically fixed, we can use the perpetuity formula for valuation:
P_0 = \frac{D}{r}Where:
- P_0 = Current price of the preference share
- D = Annual dividend per share
- r = Required rate of return (discount rate)
Example Calculation
Suppose a company issues preference shares with an annual dividend of \$5 per share. If investors require a 10% return, the fair price of the share is:
P_0 = \frac{5}{0.10} = \$50If the market price is below \$50, the shares are undervalued, presenting a buying opportunity.
Preference Shares vs. Common Shares vs. Bonds
To better understand where preference shares stand, let’s compare them with common shares and corporate bonds:
| Feature | Preference Shares | Common Shares | Bonds |
|---|---|---|---|
| Dividend/Interest | Fixed dividends | Variable dividends | Fixed interest |
| Voting Rights | Usually none | Yes | No |
| Priority in Claims | Above common, below bonds | Lowest | Highest |
| Maturity | Perpetual or redeemable | No maturity | Fixed maturity date |
| Tax Treatment | Dividends not tax-deductible | Dividends not tax-deductible | Interest is tax-deductible |
Tax Implications
In the U.S., dividends from preference shares are taxed differently than bond interest. While bond interest is taxed as ordinary income, qualified preferred dividends benefit from lower tax rates (0%, 15%, or 20%, depending on the investor’s income). However, not all preference shares qualify for this treatment—some are taxed as ordinary income.
Real-World Applications
Many blue-chip companies, such as Bank of America and Berkshire Hathaway, have issued preference shares to raise capital without diluting voting power. During the 2008 financial crisis, the U.S. Treasury invested in preference shares of major banks under the Troubled Asset Relief Program (TARP), highlighting their role in stabilizing financial markets.
Risks Associated with Preference Shares
While preference shares are generally considered safer than common stock, they carry risks:
- Interest Rate Risk – Rising interest rates make fixed dividends less attractive, lowering share prices.
- Credit Risk – If the issuing company faces financial distress, dividends may be suspended.
- Liquidity Risk – Preference shares trade less frequently than common stock, potentially making them harder to sell.
Conclusion
Preference share capital is a sophisticated financial instrument that bridges the gap between debt and equity. For investors, it offers stable income with lower risk than common stock. For companies, it provides flexible financing without surrendering control. By mastering the nuances of preference shares, finance students can better analyze corporate capital structures and investment opportunities.
