by Preference shares are a type of share that gives investors a fixed dividend and priority over equity shareholders in receiving payments. They are called preference shares because holders get preference in dividend payment and repayment during company liquidation. Companies in India use preference shares to raise long-term funds without giving voting rights to investors. These shares are suitable for investors who want steady income with lower risk compared to equity shares. Preference shareholders do not control management decisions, but they enjoy financial safety. They help companies balance their capital structure and reduce dependence on loans. Preference shares are useful for financing expansion, improving stability, and attracting conservative investors.
Types of Preference Shares:
1. Cumulative Preference Shares
Cumulative preference shares ensure that any unpaid dividends in a financial year accumulate as arrears and must be paid to these shareholders in full before any dividend can be declared for equity shareholders in subsequent profitable years. This feature provides a significant safety net for investors against temporary downturns in company profits. It prioritizes their dividend entitlement, making the instrument less risky than non-cumulative shares. For the company, while it provides patient capital, it creates a contingent liability on future profits, which can strain cash flows when profits resume.
2. Non-Cumulative Preference Shares
With non-cumulative preference shares, dividends are payable only if declared out of the profits of the current year. If the company skips a dividend in a particular year due to insufficient profits, the right to that dividend is extinguished permanently and does not accumulate. This type is riskier for investors but advantageous for the issuing company, as it does not create a burden of arrears. It is common in industries with stable and predictable profits, where the likelihood of missing a dividend is low.
3. Participating Preference Shares
Participating preference shares grant shareholders the right to a fixed preferential dividend plus an additional share in the surplus profits of the company after equity shareholders have been paid a specified rate of dividend. They may also have a right to participate in the surplus assets during winding up. This feature allows investors to benefit from the company’s exceptional performance, combining the safety of fixed income with the upside potential of equity. It is an attractive tool for raising capital from investors seeking both security and growth.
4. Non-Participating Preference Shares
Non-participating preference shares are entitled only to a fixed rate of dividend and do not have any right to share in the surplus profits or assets beyond their prefixed capital amount. This is the most common type. Their return is strictly limited, which makes them more akin to a debt instrument. For the company, it is a straightforward, predictable source of capital with no further profit-sharing obligations, leaving all excess returns for the equity shareholders.
5. Convertible Preference Shares
These shares carry the right to be converted into a predetermined number of equity shares of the company after a specified period or at the option of the shareholder. This conversion feature offers investors the security of a fixed dividend initially and the growth potential of equity later. For the company, it is an attractive way to raise capital at a lower initial cost (as the convertibility feature compensates for a lower dividend rate) and potentially reduce fixed obligations in the future upon conversion.
6. Non-Convertible Preference Shares
Non-convertible preference shares do not carry any option to convert into equity shares. They remain as preference capital until redeemed or the company is wound up. This type appeals to conservative investors seeking stable income without exposure to the volatility of equity markets. For the firm, it represents a permanent or long-term fixed-cost capital without the risk of dilution of ownership and control that conversion would entail.
7. Redeemable Preference Shares
Redeemable preference shares are issued with the understanding that the company will repay the principal amount (face value) to shareholders after a fixed maturity period or at a predetermined future date, as per the terms of issue. They function like a quasi-debt instrument but with dividend payments instead of interest. This provides a clear exit for investors and helps the company manage its capital structure by retiring expensive capital. Redemption can be funded from profits, fresh issues, or a capital redemption reserve.
8. Irredeemable Preference Shares
Irredeemable preference shares, also known as perpetual preference shares, have no fixed maturity date. The company is not obligated to repay the principal amount except in the event of winding up. From the company’s perspective, this represents permanent capital, similar to equity, providing long-term financial stability. For investors, it is a perpetuity, offering a fixed income stream indefinitely. However, these are less common today due to regulatory preferences for instruments with defined maturity.
Features of Preference Shares:
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Priority in Dividend Payment
Preference shareholders have a right to receive a fixed dividend before any dividend is declared and paid to equity shareholders. This dividend is typically expressed as a percentage of the face value. This priority ensures a more predictable income stream for investors, making the shares less risky than ordinary equity. However, the dividend is not a debt and is payable only if the company has sufficient distributable profits.
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Priority in Repayment of Capital
In the event of a company’s winding up or liquidation, preference shareholders have a preferential right over equity shareholders to the repayment of their capital. They are paid after all external debts and creditors are settled but before any amount is returned to equity holders. This feature provides an additional layer of capital protection, ranking them senior to common stock in the capital structure.
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Fixed Rate of Dividend
Preference shares carry a predetermined, fixed dividend rate (e.g., 8%). This rate does not fluctuate with the company’s profits, unlike equity dividends. This fixed nature provides certainty to investors, making preference shares resemble a fixed-income instrument. However, it also means shareholders do not benefit from higher profits, as their return is capped at the agreed rate.
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Limited Voting Rights
Generally, preference shareholders do not have voting rights in the company’s general meetings. This preserves control for equity shareholders (promoters). However, voting rights are often activated under specific conditions, such as when dividend arrears exceed a certain period (e.g., two years for cumulative shares). This conditional voting is a protective mechanism for investors.
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Convertibility Feature (Optional)
Some preference shares are issued as convertible, meaning they can be converted into a specified number of equity shares after a predetermined period. This feature combines the security of fixed dividends with the growth potential of equity. It makes the instrument attractive to investors seeking capital appreciation while allowing companies to raise capital at a lower initial dividend cost.
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Redeemability Feature (Optional)
Preference shares can be redeemable or irredeemable (perpetual). Redeemable shares are repaid by the company after a fixed maturity period, returning the principal to investors. This feature provides a clear exit and makes them akin to dated debt. The redemption is typically done at a premium over the face value, as per the terms of issue.
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Participation in Surplus Profits (Optional)
Participating preference shares carry the right to share in the surplus profits of the company after a specified dividend has been paid to equity shareholders. They may also participate in the surplus assets during winding up. This hybrid feature provides an upside beyond the fixed dividend, making them more attractive than non-participating shares, albeit less common.
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Cumulative Dividend Rights (Optional)
Cumulative preference shares have the right to accumulate unpaid dividends for future payment. If a dividend is not paid in a year due to insufficient profits, the arrears accumulate and must be settled in full before any dividend is paid to equity shareholders. This significantly reduces dividend risk for investors and is a standard protective feature.
Cost of Preference Shares:
The cost of preference shares is the return that a company must give to preference shareholders in the form of fixed dividends. It works like the price the company pays for using money raised through preference capital. Since dividends on preference shares are not tax deductible in India, the cost becomes higher than the cost of debt. Companies must plan carefully because preference dividends have to be paid regularly before paying equity shareholders. The cost helps managers compare preference shares with other sources of finance. Understanding this cost ensures the company uses preference capital only when it is beneficial and does not create long-term financial pressure.
How to Calculate Cost of Preference Shares:
1. Cost of Irredeemable Preference Shares
The cost of irredeemable preference shares is calculated using a simple formula: Annual Preference Dividend divided by Net Proceeds from the issue. Net proceeds mean the amount the company actually receives after deducting issue expenses. Since these shares are not redeemed during the company’s life, the dividend remains the only cost. This method helps companies know the fixed return they must pay to investors every year. It is easy to compute and useful for long-term financial planning. It also helps compare preference capital with debt and equity to choose the best financing option.
2. Cost of Redeemable Preference Shares
The cost of redeemable preference shares considers both the annual dividend and the redemption amount paid at maturity. The formula includes dividend plus the difference between redemption value and net proceeds, divided by the number of years to redemption. This total is then divided by the average of redemption value and net proceeds. This method gives a more accurate cost because it includes both yearly payments and the final repayment. Companies use this calculation to judge whether redeemable preference shares are affordable and suitable for long-term capital planning. It helps avoid choosing costly sources of funds that may affect profits.
Factors affecting cost of Preference Shares:
1. Dividend Rate
The dividend rate directly affects the cost of preference shares. Higher dividend rates increase the cost of raising funds through preference capital, while lower rates reduce it. Companies must offer competitive dividends to attract investors, especially when market interest rates are high. In India, investors usually expect stable and reasonable returns, so companies must balance dividend levels with affordability. If the dividend rate is too high, it becomes more expensive than debt. Choosing the right rate helps companies maintain financial stability and control overall capital costs.
2. Market Conditions
Market conditions play an important role in determining the cost of preference shares. When the market is stable and investors feel confident, companies can issue preference shares at lower dividend rates. During uncertain or recession periods, investors demand higher returns, increasing the cost. Interest rate trends, inflation, and stock market performance also influence investor expectations. Favourable market conditions help firms raise funds easily, while poor conditions may force companies to offer higher dividends. Understanding market behaviour helps companies choose the right time to issue preference shares at an affordable cost.
3. Company’s Financial Performance
A company with strong financial performance and stable profits can issue preference shares at a lower cost. Investors trust profitable companies and accept lower dividend rates because risk is low. Weak financial performance increases investor risk, forcing companies to offer higher dividends. In India, credit rating agencies and investors closely examine profitability, cash flows, and past dividend records. Strong financial health improves investor confidence and reduces the cost of preference capital. Maintaining good performance helps companies attract long-term investors without paying high returns.
4. Tax Treatment
Preference dividends are not tax deductible for companies in India. This increases the effective cost of preference capital compared to debt. If corporate tax rates change, the attractiveness of preference shares may also change. Higher taxes make debt cheaper in comparison, while lower taxes may reduce this gap. Companies must consider tax impact carefully when deciding their capital structure. Since no tax benefit is available, firms must ensure dividend payments are manageable. Understanding tax treatment helps managers avoid raising expensive funds that can reduce overall profitability.
5. Flotation Costs
Flotation costs are the expenses involved in issuing preference shares, such as underwriting fees, legal charges, and administrative costs. Higher flotation costs reduce the net proceeds received by the company, which increases the cost of preference capital. Firms with strong reputation may face lower flotation costs, while new or risky companies may pay higher charges. In India, companies must estimate these costs before issuing new shares to avoid unexpected financial burden. By reducing flotation costs through efficient planning, companies can lower the overall cost and make preference shares a more attractive financing option.
Redemption of Preference Shares:
Redemption of preference shares refers to the process of a company repurchasing or buying back its outstanding preference shares from its shareholders. The redemption of preference shares is a common way for companies to reduce their outstanding equity capital or to restructure their capital base.
It’s important to note that the redemption of preference shares in India is subject to various legal and regulatory requirements, including compliance with the Companies Act, 2013, Securities and Exchange Board of India (SEBI) regulations, and the Income Tax Act, among others. Companies should seek legal and financial advice before proceeding with the redemption of preference shares to ensure compliance with all applicable laws and regulations.
The Companies Act, 2013, governs the redemption of preference shares in India. As per the Act, companies may redeem preference shares either by:
- Paying off the shareholders in cash, or
- Issuing new preference shares in exchange for the redeemed shares.
Process of Redemption of Preference Shares:
- Check the Articles of Association:
The Articles of Association of the company should be checked to ensure that they contain provisions relating to the redemption of preference shares.
- Pass Board Resolution:
The board of directors of the company should pass a resolution approving the redemption of preference shares. The resolution should specify the number of shares to be redeemed, the price at which the shares will be redeemed, and the terms and conditions of the redemption.
- Provide notice to Shareholders:
The company should provide notice to its shareholders of its intention to redeem preference shares. The notice should specify the number of shares to be redeemed, the price at which the shares will be redeemed, and the terms and conditions of the redemption.
- Obtain Shareholder Approval:
The shareholders should approve the redemption of preference shares at a general meeting of the company. The approval should be obtained by way of an ordinary resolution.
- Redemption of Shares:
The company should redeem the preference shares by paying the shareholders in cash or by issuing new preference shares in exchange for the redeemed shares, as per the terms and conditions of the redemption.
- Filing with Registrar of Companies:
The company should file the necessary forms and documents with the Registrar of Companies within 30 days of the redemption of preference shares.
