Preference Shares

Preference Shares — Meaning, Definition & Full Explanation

Preference shares, commonly known as preferred stock, are a type of equity security that grants shareholders a fixed dividend before common shareholders receive any payments. These shares often come with specific rights regarding dividend payments and asset claims during a company's liquidation, making them a safer investment than common shares.

What is Preference Shares?

Preference shares are financial instruments issued by a company that provide shareholders with certain advantages over common shareholders. They typically offer fixed dividends, which means that shareholders receive a specified amount regularly, regardless of the company's profit levels. Unlike common shares, preference shares generally do not grant voting rights; however, they do rank higher in the hierarchy of claims on assets during bankruptcy or liquidation. This makes preference shares attractive to investors seeking stable income. They can be categorized into various types, such as cumulative, non-cumulative, convertible, and participating preference shares, each differing in their specific features and rights regarding dividends and asset claims. Preference shares exist to provide a hybrid financing mechanism that attracts a range of investors looking for lower risk compared to common shares.

How Preference Shares Work

Preference shares operate through several mechanisms:

1. Issuance: Companies issue preference shares to raise capital without diluting the voting power of existing common shareholders.
2. Fixed Dividends: Preference shareholders receive dividends at predetermined rates before any dividends are distributed to common shareholders. This provides them with a more stable income stream.
3. Priority in Liquidation: In the event of bankruptcy, preference shareholders have the right to be paid from the company's assets before common shareholders.
4. Types:
   • Cumulative Preference Shares: If dividends are missed, they accumulate and must be paid before any payments to common shareholders.
   • Non-Cumulative Preference Shares: If dividends are skipped, the shareholders do not have the right to claim those unpaid dividends in the future.
   • Convertible Preference Shares: Shareholders can convert their shares into common shares after a specified period.
   • Participating Preference Shares: Holders may receive additional dividends beyond the fixed rate if the company performs exceptionally well.

The outcome of issuing preference shares is a blend of equity and fixed income, making it a strategic financing option for businesses.

Preference Shares in Indian Banking

In India, preference shares are governed by the Companies Act, 2013, which outlines their issuance and rights. The Reserve Bank of India (RBI) primarily regulates how these shares are utilized in the banking sector. According to the RBI guidelines, banks can issue preference shares to bolster their capital base, but they must comply with prudential norms and guidelines for capital adequacy as per Basel III norms. Prominent institutions like State Bank of India (SBI) have issued preference shares to enhance their capital structure. Preference shares also appear in the syllabus for JAIIB, emphasizing their importance in financial management and corporate finance. Understanding preference shares is vital for banking professionals, as it affects a company's capital strategy and risk profile.

Practical Example

Ravi, a finance manager at a tech startup in Bengaluru, decided to raise ₹50 lakhs through preference shares to fund his growing business. He approached investors and offered convertible preference shares with a fixed dividend of 8% annually. If the company performed well, investors could eventually convert their preference shares into common equity after three years. This financing method allowed Ravi to secure necessary funds without diluting control over the company, ensuring that preferred shareholders would receive their dividends before any payouts to common shareholders. As the startup's revenues increased, Ravi could attract even more investment and eventually repay the preference shareholders or allow them to convert their shares, rewarding them handsomely.

Preference Shares vs Equity Shares

Criteria	Preference Shares	Equity Shares
Dividend Payment	Fixed dividends before equity shareholders	Dividends that vary based on profits
Voting Rights	No voting rights	Voting rights in company matters
Claim on Assets	Higher claim during liquidation	Lower claim during liquidation
Types Available	Cumulative, Non-Cumulative, Convertible	Common Equity Shares

Preference shares are ideal for investors seeking fixed returns and lower risk, while equity shares are more suited for those looking for growth and voting power in corporate decisions. Investors must choose based on their risk tolerance and investment goals.

Key Takeaways

• Preference shares provide fixed dividends before common shareholders receive any payments.
• They rank higher than common shares in the event of liquidation or bankruptcy.
• Types include cumulative, non-cumulative, convertible, and participating preference shares.
• They are regulated under the Companies Act, 2013, and guidelines by the RBI.
• Investment in preference shares is often considered lower risk compared to common shares.
• Preference shares may not carry voting rights, limiting shareholder influence.
• They play a crucial role in capital structure management for many companies.
• Understanding preference shares is vital for banking exams like JAIIB and CAIIB.

Frequently Asked Questions

Q: Are preference shares taxable?
A: Yes, dividends received from preference shares are taxable in India as per the provisions of the Income Tax Act. The tax treatment may vary based on the investor's income slab.

Q: What is the difference between cumulative and non-cumulative preference shares?
A: Cumulative preference shares accumulate unpaid dividends, which must be paid before common dividends. In contrast, non-cumulative preference shares do not allow claims for missed dividends, meaning investors forfeit those if payments are skipped.

Q: How do preference shares affect a company’s financial stability?
A: Preference shares can enhance a company's financial stability by providing a stable source of capital while minimizing dilution of control. They also signal financial health by attracting risk-averse investors looking for fixed returns.