By: Tavaga Research
What are Preference Shares?
Preference share or preferred equity is similar to the common share of a company in terms of ownership. However, preferred equity does not hold voting rights.
Preference shares are suitable for investors who want a steady source of income without taking on the risks of volatility in the common shares. Preference shareholders also give up the upside potential of common shares as preference shares do not change their value substantially in any given holding period.
In case of bankruptcy, preference shares will be paid before common shareholders. Notably, preference shareholders are paid a fixed dividend on the par value of the preference share. Par value of a share is the value of the share as listen in the company’s charter and is usually lower than the actual fair value of the preferred equity.
A preference share is an equity instrument but also has characteristics of a debt instrument such as a fixed payment of dividend and callability. Therefore, preference shares fall on the blurred line between debt and equity and are generally considered hybrid in nature
For example, a 5% preference share with a face value of Rs. 100 will pay Rs. 5 as dividends every year. If the required market rate of return on similar preference shares is more than 5% then the shares will trade on a discount, and will result in capital loss for an investor who purchases the shares in the initial offering at the face value. If the required market rate of return is less than 5% then the shares will trade at a premium to their face value.
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Why are Preference Shares issued?
- Unlike common shares, preference shares are not volatile in nature and are suitable to market them to institutional investors during an IPO. Investors in preferred equity are also subject to friendly tax provisions on dividends earned.
- Unlike timely payment of interest on bonds issued by the company, dividend on preference share can be paid as per the company’s cash status. The company can pay the cumulative amounts of dividends whenever they find it convenient. On the other hand, defaulting on interest payments for bond issues results in a downgrade of the company’s credit standing.
What are the types of Preference Shares?
- Cumulative Preference Shares: A most common type of preferred equity where the dividends, if not paid, are considered in arrears and are given priority over other dividend payments. In other words, if the company doesn’t have the ability to meet the obligation of paying dividends to its shareholders, the cumulative dividends can be paid in later years as arrears. The law forbids the company to make any dividend payment to common shareholders, unless and until the preference shareholders receive dividends. Preference share can be cumulative or non-cumulative
- Non-cumulative Preference Shares: This category of shareholders are not compensated for unpaid dividends, unlike the cumulative preference shares. For example, if a company skips the dividend payment after making an announcement, the company is under no obligation to adhere to its earlier announcement of paying dividends
- Redeemable Preference Shares: A company issues redeemable preference shares to redeem them at a later stage. Simply put, the company can opt for a buy-back in the future
- Irredeemable Preference Shares: This category of shares can only be redeemed if the company shuts its operations or liquidates itself
- Adjustable-Rate Preference Shares: There is no provision for a fixed dividend rate under this category, the dividend payment depends upon existing interest rates in the market
- Callable Preference Shares: Being hybrid security, the issuing company is given the right to redeem the shares at a certain date and price specified at the time of issuance. This characteristic makes preferred equity less appealing to the investors
- Convertible Preference Shares: Shares are convertible to common equity at a certain time and price; considered the most versatile and appealing form of preferred equity with diversified risk exposure
- Non-Convertible Preference Shares: Shareholders who own non-convertible preference shares, do not possess the right to convert those into common equity
- Participating Preference Shares: Another common classification for preferred equity, where if the shares are participating, they stand a chance to earn higher than the state rate of fixed dividend The dividends on participating preference shares are higher if the company earns more than the stated benchmark of earnings.
- Non-Participating Preference Shares: Dividend to the shareholders from this category cannot be paid from surplus profit and only enjoy the fixed dividend rate
Is Preference Share debt or equity?
Preference Shares have characteristics similar to that of debt and equity, as they distribute dividends like bonds, and they carry equity risk as the principal amount is not secured.
Can Preference Shares qualify for a buy-back?
Like common equity, preference shares too can be repurchased. Redemption of preference shares at maturity is not necessary as they do qualify for buy-back like equity shares.
Can Preference shares be issued at a premium?
Yes, preference shares can be issued at a premium.
What are the conditions and guidelines for issuing preference shares?
- As per section 55 of the Companies Act, only redeemable shares can be issued by a company. The Companies Act prohibits a company to issue irredeemable preference shares
- Preference shares must be mandatorily redeemed by the issuing company within a period of 20 years from the date of issuance. There is a provision where the redemption period can go beyond 20 years, however, in this situation, the shareholder must have the option to partially get his preference shares redeemed annually
- To take the private placement route for issuing securities, the issuing company is required by law to send an offer letter to the people part of the company to whom shares are being issued
What are the conditions to redeem preference shares?
- Redemption of only fully paid-up preference shares is permitted
- Redemption of preference shares is only allowed from:
- Profits available for distribution to shareholders
- The proceeds of equity/preference shares issued solely for the purpose of preference shares redemption
- If the company intends to redeem preference shares from the fresh proceeds of newly issued preference shares, at least 75% of the shareholders must provide the consent to carry out this activity, along with the tribunal’s approval
- Once the consent is provided by the existing shareholders and the necessary approvals are sought from the tribunal, the shareholders who initially opposed the issuance of new preference shares for the purpose of redeeming existing preference shares will get their shares redeemed on an immediate basis as per the orders of the tribunal.
- Moreover, the preference shares issued for redeeming old preference shares cannot be added to the existing share capital of the company
What is the similarity between Preference Shares and Bond?
- Interest Rate Sensitivity: Like any other fixed-income instrument, preference share is also sensitive to interest rates. If the market is offering higher interest than the rate of dividend, the market value of preference share falls
- Callability: The preference shares can be called by the issuer, which is essentially redemption of shares, at a certain price and time. This happens when the company has to pay a higher dividend on the shares than the prevailing market rate of interest
- Seniority: Bonds and Preferences shares are senior instruments in that they rank higher than common shares. In case of bankruptcy, the due amount for senior securities is serviced first.
- Credit Rating: Like bonds, preference shares also have a credit rating issued from credit rating companies such as Moody’s depending on the quality of the company and payment of dividends
What is the difference between Preference Shares and Bond?
- Classification: Bonds are classified as debt and preference shares as equity
- Payment of dividends: The dividends are fixed but not guaranteed, unlike interest on bonds which have to be paid as per the debt schedule
- Tradability: Preference shares are more liquid as they trade on the stock exchange. Bonds are generally over-the-market securities with a negligible presence on the exchange
What is the similarity between Preference Shares and Equity Shares?
- Classification: Preference Shares are classified as an equity and are very similar to the general equity offered by the company. Like any other equity instrument, preference shares are paid dividends from profit after tax but preference shares have a fixed rate of dividend.
What is the difference between Preference Shares and Equity Shares?
- Voting rights: Common equity holds voting rights which is not the case for preferred equity
- Payments: Common shares are not entitled to a fixed dividend, the company may or may not announce dividends to common shareholders. However, preferred equity attracts dividends, cumulative or non-cumulative. In an event of bankruptcy, the preferred shareholders get their claims before the common shareholders.
- Volatility: Preferred equity lacks appeal when it comes to price appreciation. Common shares react actively to market developments on a daily basis. Preferred equity is very fundamental in nature and follows steady price movements and therefore offers mediocre returns.
How is the value of preference shares determined?
Common shares are valued on the basis of future earnings per share. Similarly, preferred equity is entitled to dividends and can be valued as per the sum of the present value of future dividends per share.
If the dividends can be forecasted with precision, they can be discounted to their present value using the required rate of return on the preferred equity. The required rate of return is generally a factor of quality of the issuing company, features of the share (callable, participating, etc.), and risk factors associated with bankruptcy.
Suppose dividends are Rs 50, Rs 75, and Rs 100 in the first 3 years and the required rate of returns is 7% per annum. The share can be valued at approximately Rs 194 in the following way:
Constant growth can be incorporated in the formula as well to find the perpetual value of a preference share. The formula can be:
D = Current Dividends
R = Required rate of Return
G = Constant Growth rate of Dividends
The price of a share in the live market is made up of three variables: Face value, Premium on the face value, and Accrued Dividend
The returns on preference shares are similar to bonds. The return consists of 2 components: 1. The dividends and 2. The market value or price of the share. For example, if you bought a 5% preference share of face value Rs.100, currently trading at Rs. 100, your return for a holding period of 1 year will be as follows:
In a situation when the market price of preferred
share after 1 year is Rs.110, then
Dividend return = Rs. 5
Capital Gain = Rs. 10
Return over 1 year holding period = (10+5) / 100 = 15%
Why should you buy a Preference Share?
- Regular income in the form of dividends
- Higher potential for returns as compared to bonds
- Lower risk as compared to common shares can be suitable for risk-averse investors
- Dividend income on preference shares is tax-free up to Rs 10,00,000 (pertaining to Indian tax laws)
How to purchase Preference Share in India?
Preference Shares can be purchased through the primary market (in case of an IPO or FPO) or through the secondary market (on the exchange or over the counter) depending on their listing status.
For online trading, investors must have a demat account.
The minimum amount of investment is Rs 10,00,000 in case of a private placement of preference shares.
For a public issue, the minimum amount can be as low as Rs 10.