Definition of Preference share:
A company needs finance to meet its various types of requirements.While some fund are required for a fairly long time for the purpose of acquiring fixed assets,some other are required for day to day working.Raising capital by issue of shares is a most
important method of raising long-term funds. Those funds can be invested in
long-term or permanent assets like land and building, plant and machinery,
furniture etc. A share is unit of measure of a shareholder's interest in the
total capital of the company. Share capital of a company is divided into a
large number of equal parts and each part is known is a share. According to
Companies Act, a company can issue two types of shares -preference and equity.
Preference shares. Sec. 85(1) of the Companies
Act defines preference shares as those shares which carry preferential rights
as the payment of dividend at a fixed rate and as to repayment of capital in
case of winding up of the company. Thus, both the preferential rights viz. (a)
preference in payment of dividend and (b) preference in repayment of capital in
case of winding up of the company, must attach to preference shares. The rate
of dividend on these shares is fixed and the dividend on these shares must be
paid before any dividend is paid to ordinary shares. Directors, however, may
decide not to pay any dividend to any class of shareholders even if there are
sufficient profits. But, if any how, they decide to pay the dividend,
preference shareholders will get the priority to pay the ordinary shareholders.
Preference shares may be classified
according to the rights attached to them as follows:
Cumulative and Non-cumulative Preference
shares
The holders of cumulative preference share are entitled to arrears of dividend on their share to be paid out of profits of subsequent years.Cumulative preference shares enjoy the right to receive the dividend in
arrears for the years in which company earned no profits or insufficient
profits, in the year in which company earns profits. In other words, dividend
on these shares will go on accumulating until it is paid in full with arrears,
before any dividend is paid on equity shareholders. In case of non-cumulative
preference shares dividend does not accumulate and therefore, no arrears of
dividend will be paid in the year of profits. If company does not have any
profits in a year, no dividend will be paid to non-cumulative preference
shareholders.
Redeemable and Irredeemable Preference
Shares
Redeemable preference shares are those which will be repaid on or after a certain date in accordance with the terms of issue.Redeemable preference shares can be redeemed on or after a period fixed for
redemption under the terms of issue or after giving a proper notice of
redemption to preference shareholders. The companies Act, however, impose
certain restrictions for the redemption of preference shares. Irredeemable
preference shares are those shares which cannot be redeemed during the lifetime
of the company. (We are going to Sale here only Redeemable Preference
Shares).
Convertible and Non-convertible
preference shares
Convertible preference shares are those preference shares which are given a right to be converted into equity share within a fixed period of time.Preference shareholders are given a right to covert their holding
into ordinary shares, within a specified period of time, such shares as known
as convertible preference shares. The holders of non-convertible preference
shares have no such right of conversion.
Participating and Non-participating
Preference Shares
The holders of participating preference shares have a right to participate
in the surplus profits of the company remained after paying dividend to the
ordinary shareholders and preference shareholders at a fixed rate. The
preference shares which do not have such right to participate in surplus
profits, are known as non-participating preference shares.
The advantages of Preference shares are
as follows:
(A) Advantages from Company point of
view:
The company has the following advantages by issue
of preference shares.
I. Fixed Return: The dividend payable on preference shares
is fixed that is usually lower than that payable on equity shares. Thus they
help the company in maximizing the profits available for dividend to equity
shareholders.
II. No Voting Right: Preference shareholders have no voting
right on matters not directly affecting their right hence promoters or
management can retain control over the affairs of the company.
III. Flexibility in Capital Structure: The Company can
maintain flexibility in its capital structure by issuing redeemable preference
shares as they can be redeemed under terms of issue.
IV. No Burden on Finance: Issue of preference shares does
not prove a burden on the finance of the company because dividends are paid
only if profits are available otherwise no dividend.
V.No Charge on Assets: No-payment of dividend on preference
shares does not create a charge on the assets of the company as is in the case
of debentures.
VI. Wide Capital Market: The issue of preference shares
widens the scope of capital market as they provide the safety to the investors
as well as a fixed rate of return. If company does not issue preference shares,
it will not be able to attract the capital from such moderate type of
investors.
(B) Advantages from Investors point of
view:
Investors in preference shares have the following
advantages:
I. Regular Fixed Income: Investors in cumulative preference
shares get a fixed rate of dividend on preference share regularly even if there
is no profit. Arrears of dividend, if any, is paid in the year's) of profits.
II. Preferential Rights: Preference shares carry
preferential right as regard to payment of dividend and preferential as regards
repayment of capital in case of winding up of company. Thus they enjoy the
minimum risk.
III. Voting Right for Safety of Interest: Preference
shareholders are given voting rights in matters directly affecting their
interest. It means, their interest is safeguarded.
IV. Lesser Capital Losses: As the preference shareholders
enjoy the preferential right of repayment of their capital in case of winding
up of company, it saves them from capital losses.
V. Fair Security: Preference share are fair securities for
the shareholders during depression periods when the profits of the company are
down.
The Disadvantages of Preference Shares
are as follows:
The important disadvantages of the issue of
preference shares are as below:
(A) Demerits for companies:
The following disadvantages to the issuing
company are associated with the issue of preference shares.
I. Higher Rate of Dividend: Company is to pay higher
dividend on these shares than the prevailing rate of interest on debentures of
bonds. Thus, it usually increases the cost of capital for the company.
II. Financial Burden: Most of the preference shares are
issued cumulative which means that all the arrears of preference dividend must
be paid before anything can be paid to equity shareholders. The company is
under an obligation to pay dividend on such shares. It thus, reduces the
profits for equity shareholders.
III. Dilution of Claim over Assets: The issue of preference
shares involves dilution of equity shareholders claim over the assets of the
company because preference shareholders have the preferential right on the
assets of the company in case of winding up.
IV. Adverse effect on credit-worthiness: The credit
worthiness of the company is seriously affected by the issue of preference
shares. The creditors may anticipate that the continuance of dividend on
preference shares and suspension of dividend on equity capital may deprived
them of the chance of getting back their principal in full in the event
of dissolution of the company, because preference capital has the preference
right over the assets of the company.
V. Tax disadvantage: The taxable income is not reduced by
the amount of preference dividend while in case of debentures or bonds; the
interest paid to them is deductible in full.
(B) Demerits for Investors:
Main disadvantages of preference shares
to investors are:
I. No Voting Right: The preference shareholders do not
enjoy any voting right except in matters directed affecting their interest.
II. Fixed Income: The dividend on preference shares other
than participating preference shares is fixed even if the company earns higher
profits.
III. No claim over surplus: The preferential shareholders
have no claim over the surplus. They can only ask for the return of their
capital investment in the company.
Inquiry Regarding preference share Contact. Email:
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