What are Preference Shares?
Preference shares, also known as preferred stock, are a type of equity security that provides certain privileges over common shares. They are called “preference” shares because they give shareholders preferential treatment in terms of dividends and claim on assets in the event of a company’s liquidation.
Key Characteristics of Preference Shares
- Fixed Dividends: Unlike common shares, preference shares usually come with a fixed dividend. This means that holders of preference shares receive a set dividend amount regularly, similar to interest payments on bonds.
- Priority Over Common Shares: Preference shareholders have priority over common shareholders when it comes to dividend payments and claims on company assets. In the event of liquidation, preference shareholders are paid before common shareholders but after debt holders.
- Non-voting Rights: Typically, preference shareholders do not have voting rights in the company’s general meetings. This distinguishes them from common shareholders, who usually have the right to vote on important corporate matters.
- Callable at Company’s Option: Many preference shares are callable, meaning the issuing company can repurchase them at a predetermined price after a certain date.
- Convertible Features: Some preference shares are convertible, allowing shareholders to convert their preference shares into a specified number of common shares under certain conditions.
Types of Preference Shares
- Cumulative Preference Shares: These shares accumulate unpaid dividends. 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: These do not accumulate unpaid dividends. If a company skips a dividend payment, shareholders do not have the right to claim the missed dividends in the future.
- Participating Preference Shares: These shares offer additional dividends if the company performs well, beyond the fixed dividend rate. Shareholders may receive extra dividends based on specific conditions, such as profits exceeding a certain level.
- Convertible Preference Shares: These can be converted into a predetermined number of common shares, providing potential for capital appreciation if the company’s common shares perform well.
Importance of Preference Shares
- Stable Income for Investors: Preference shares are attractive to investors seeking stable and predictable income. The fixed dividend payments offer a regular income stream, making them similar to bonds.
- Less Risky Than Common Shares: Preference shares are less risky than common shares because of their priority in dividend payments and claims on assets. This makes them a safer investment during economic downturns.
- Flexible Financing for Companies: For companies, issuing preference shares can be a flexible way to raise capital without diluting control, as preference shareholders generally do not have voting rights.
Example of Preference Shares
Imagine a company, ABC Corp., issues 1,000 preference shares at $100 each, with a fixed annual dividend rate of 5%.
- Fixed Dividend: Each preference shareholder receives an annual dividend of $5 per share (5% of $100).
- Priority in Liquidation: In case ABC Corp. faces liquidation, preference shareholders will be paid from the company’s assets before common shareholders, ensuring they receive their investment back, provided there are sufficient assets.
Practical Application
Advantages for Investors
- Guaranteed Dividends: Preference shareholders receive fixed dividends, providing a reliable income.
- Reduced Risk: The priority in dividend payments and claims on assets offers greater security compared to common shares.
- Potential for Conversion: Convertible preference shares allow investors to benefit from the potential appreciation of common shares.
Advantages for Companies
- Capital Raising: Preference shares help companies raise capital without giving up control, as these shares usually do not come with voting rights.
- Flexible Payment Options: Companies can choose the terms of the preference shares, such as whether they are cumulative, non-cumulative, callable, or convertible.
Real-World Example
Consider XYZ Ltd., which issues 2,000 cumulative preference shares at $50 each with an annual dividend rate of 6%.
- Fixed Dividend: Each preference shareholder receives $3 annually per share (6% of $50).
- Cumulative Feature: If XYZ Ltd. skips a dividend payment one year, it must pay the missed dividend ($3 per share) in subsequent years before paying any dividends to common shareholders.
References for Further Reading
To deepen your understanding, consider exploring:
- Corporate Finance Textbooks: These provide detailed explanations of different types of equity securities, including preference shares.
- Investment Guides: Books and articles focusing on investment strategies often discuss the role and benefits of preference shares.
- Financial Market Regulations: Understanding the legal aspects governing preference shares can offer insights into investor rights and company obligations.
Conclusion
Preference shares are a unique financial instrument that combines features of both equity and debt. They offer investors a stable income through fixed dividends and provide a safer investment option compared to common shares due to their priority in dividend payments and claims on assets. For companies, issuing preference shares is a strategic way to raise capital without diluting control. Understanding the characteristics, advantages, and practical applications of preference shares is essential for anyone involved in finance and investment.