- Preference shares are a type of ownership in a company that have some characteristics of both debt and equity. In this section, we will discuss preference shares as a source of finance for a company.
Features of preference shares:
- Preference shares represent ownership in a company, but they have different features from ordinary shares.
- They typically pay a fixed dividend to shareholders, which must be paid before any dividends are paid to ordinary shareholders.
- In the event of liquidation, preference shareholders have a higher claim on the company’s assets than ordinary shareholders.
- Preference shares may be convertible into ordinary shares, allowing investors to participate in the growth of the company.
Types of Preference Shares:
- Cumulative preference shares:
- Fixed dividend paid to shareholders
- If dividend can’t be paid in a given year, it accumulates and must be paid before dividends to ordinary shareholders
- Lower risk than ordinary shares
- Non-cumulative preference shares:
- Fixed dividend paid to shareholders
- If dividend can’t be paid in a given year, it does not accumulate
- Lower risk than ordinary shares
- Participating preference shares:
- Fixed dividend paid to shareholders
- Shareholders also have the right to participate in any additional profits beyond the fixed dividend
- Higher risk and potentially higher return than other types of preference shares
- Convertible preference shares:
- Fixed dividend paid to shareholders
- Shareholders have the right to convert their shares into ordinary shares at a predetermined price
- Offers potential for capital appreciation and higher return than other types of preference shares
- Redeemable preference shares:
- Have a fixed maturity date
- Company has the right to redeem the shares at a predetermined price on or after the maturity date
- Offers more flexibility to the company than other types of preference shares
Situations where preference shares may be appropriate:
- Companies that have a stable earnings history and can reliably pay a fixed dividend may be attractive to investors looking for a steady income stream.
- Companies that are not able to secure debt financing at a reasonable cost may turn to preference shares as an alternative source of financing.
- Companies that want to maintain control over their operations may prefer to issue preference shares rather than ordinary shares, as preference shareholders typically do not have voting rights.
Benefits of preference shares as a source of finance:
- They can provide a steady source of income for investors, which may make them more attractive to certain types of investors.
- Preference shares may be less risky than equity financing, as the fixed dividend provides some stability for investors.
- Preference shares do not dilute ownership or control of the company in the same way that issuing ordinary shares does.
Drawbacks of preference shares as a source of finance:
- The fixed dividend payments can be a burden for companies if they experience financial difficulties or a downturn in earnings.
- Preference shares may be more expensive than debt financing, as investors typically require a higher rate of return to compensate for the added risk.
- The lack of voting rights for preference shareholders can be a disadvantage for companies that want to maintain close relationships with their investors.
