A preference share is a special category of dividends that are paid before the common stock dividends are issued. Moreover, the shareholders of preference shares hold preferential rights while sharing profits over the common stockholders.
Suppose, if a company faces bankruptcy, then the shareholders of the preference shares have the first right over the company assets and are issued the dividends first before the common stockholders. However, as opposed to common stock investors, preference shareholders do not have voting rights and are paid a fixed dividend.
The dividend earns from the preference shares is advantageous in the long run. Moreover, the preference returns are comparatively higher than the other ordinary shares. They include the essence of both debt and equity shares which it refers to as hybrid financing instruments.
Preference shares act as earners during phases like low economic growth. Furthermore, the features of preference shares are as follows:
- Preference shares are a long-term source of finance that is non-tax deductible with a fixed rate of dividend despite any amount of profits.
- Due to the first rights over the dividend of the company, preference shares have more significance than the other standard shareholders.
- There are no voting rights in the business proceedings to the shareholders which becomes the major reason why the company offers these shares.
- One feature that does not spotlight is to know that preference share includes the payment of dividends on specific dates rather entirely a monthly income.
- However, irredeemable preference shares need a look upon, since the shareholder has a certain say on his maturity date.
- The preferences share seems identical to PAT since the tax decides on the dividend payable on the prearranged fund of dividend.
- Also, preference shares are costlier to issue as compared to debt.
How To Calculate Preferred Stock
The formula below along with an example explains how to calculate preferred stock. The calculation for the cost of preferred stock, however, is similar to the perpetuity formula.
How to calculate the preferred stock formula:
Rp = D / Po Where D = Dividend , Po = Current Price
For example,
Question: How to calculate preferred stock when the annual dividend paid for it is $4 with a current price of $25.
Answer: Rp= 4 / 25 = 16%
The company’s management chooses among the best alternatives among the financing options by analyzing the costs. As a result, when preferred stock is paid dividends each year then it is included in the price of raising capital.
Since the cost of common stock varies with the demand and supply forces of the market, therefore, preferred stock is considered more valuable which ensures greater security if the company defaults or folds.
To determine what are preference share types, its important to understand it is differentiation is based on the clause at the time of issue in the agreement which is major as follows:
Non-cumulative preference shares
Firstly, non-cumulative dividends if not paid do not accumulate when they are due. The dividend for these types of shares is paid only via current-year profits i.e if the company does not earn sufficient profits, the shareholders get partial or no dividends. Moreover, the holders can neither claim for arrears nor the unpaid dividend carried forward to successive years.
Cumulative preference shares
Secondly, the right to dividends even when the company makes no profit is termed cumulative preference shares. This explains that whenever the company makes inadequate profits, the dividends may not be paid in the current year but are treated as arrears. Therefore, it accumulates and is payable in successive years’ profits. Moreover, other types of shares can be paid only after the fulfilment of arrears. The company pays the shareholders before the dividends of equity.
Non-participating preference shares
In these types of shares, the shareholders receive the stated dividends only. The investors surrender to claim extra earnings for the right to receive the dividend stated. The non-participating preference shares neither have the right to surplus profits left after equity shares payment(during lifetime) nor in surplus assets(during winding up).
Participating preference shares
Fourthly, the shares which receive a stipulated rate of dividends and also get a share in additional earnings along with equity investors are termed participating preference shares. The shareholders have the right over the surpluses left during the lifetime of the company after paying all types and in surplus assets during winding up along with equity shareholders in an agreed ratio.
Non-Redeemable preference shares
Next explains the shares that are permanent with continuous shareholding until the company reaches the level of liquidation. As a result, the investors redeem the preference shares after the expiry of the mentioned period. Also, the clause of incorporation for redemption does not exist and therefore cannot be bought back by the wish of issuing company.
Redeemable preference shares
Also termed as option embedded, the shares that can be redeemed after the discretion of the company or after the mentioned period are known as redeemable preference shares. However, this kind is advantageous for the company which acts as a hedge against inflation. This happens when the rate declines, the company redeem the shares or refinances them at a lower rate. Here, in the clause, the redemption price range is predetermined and the company can even buy back the shares before the specified period.
Convertible preference shares
Convertible preference shares are those that can be converted into equity shares on the expiry of the specified period at the stated rate. The holders have the right to convert them into equity shares. This kind of share may also include participating or cumulative rights. As a result, these types of shares become ideal from the vision of investors.
Non-convertible preference shares
These types of shares are opposite to the convertible shares discussed above. Non-convertible preference shareholders do not have the right of conversion into equity shares. However, there is an additional point that non-convertible preference shares can also be redeemed.
Preferred stock examples
- In various countries, the issuance of preferred stock is encouraged in banks for the source of Tier 1 capital. However, preferred stocks become common in pre-public or private companies where the differentiation in economic interest and control of the company is useful.
- A company going for venture capital or other types of funding may wish to go for various rounds of financing to issue several classes of preference shares.
- In the United States, there are two preferred stock examples; one convertible and the other straight. Straight preferred stock examples issue stipulated dividend rates in perpetuity whereas a convertible preferred stock example converts into common stock under certain conditions.
Preferred stock vs Common stock
Voting rights
In the main topic of preferred stock vs common stock, the major point of differentiation is that preference shareholders have no voting rights. This explains that the preferred stock investors do not have a say in future of the company whereas the common stockholders have.
Dividends
The investors for preferred stock are paid a fixed dividend in perpetuity. However, this scenario is different in common stock where the dividends are variable, declares BOD and never guaranteed.
Value
In preferred stock vs common stock, the par value of the preferred stocks also affects by interest rates(a rise in interest rates or price level accounting decreases the value of the stock). Whereas, the value of common shares regulates by the supply and demand of the market participants.
Payment during defaults
Preferred stock arrears of dividends are paid before the common shareholders. During liquidation, the preferred stock investors have a higher claim for company earnings and assets.
Callability
The character of callability in preferred stock allows the investor the redeem shares after a specified period. The different types of preference shares allow them to call back at a redemption rate. Where the prices may bid up accordingly not offered by common stock.
| BASICS | PREFERRED STOCK | COMMON STOCK |
| Voting rights | No | Yes |
| dividends | Fixed | Varies |
| Value till maturity | Remains full | Varies |
| Payment order if the company defaults | Second | Third |
| Categorization | Further subcategories | No further division |
| Risk and return | Less risky and lower returns | Greater risk but higher returns |
Frequently Asked Questions (FAQs)
What Is A Preference Share?
Preference shares are exclusive shares which gives rights to the shareholder to receive the dividend before equity shareholders while holding the right to vote in the company.
What is an example of preference shares?
Suppose that Company ‘C’ has a total of 10,000 preference shares to distribute among its investors. These shares are priced at ₹100 earning interest at 8% per annum.
For the years 2020 and 2021, C company has not paid dividends to its preferred shareholders.
Before the company can pay its regular shareholders in 2022, the preference shareholders are eligible to receive ₹2,40,000 by the time 2020 rolls around.
What is equity and preference share?
Equity shares represent the extent of ownership in a company. Preference shares come with preferential rights when it comes to receiving dividends or repaying capital.
What is preference share and its advantages?
Advantages to investors
- Preference shareholders earn fixed dividends and may also benefit from capital appreciation.
- Preference shareholders enjoy preference over equity shareholders for dividend payments.
- Preference shareholders have the right to claim the company’s assets before equity shareholders in case of company liquidation, which makes it a less risky investment than equity.