What is Preference Share?

Preference Shares- Meaning, Types, Merits and limitations

Preference Shares- Meaning

As pointed out earlier preference shares are those shares, which have preferential right:

  1. regarding payment of dividend these shares preference over other shareholders, and
  2. regarding return of capital these get preference over other shareholders in case the company goes into liquidation.

The rate of dividend on preference shares is fixed. However, participating preference shareholders have a further right to dividend after dividend at a certain rate has been paid to the equity shareholders. They do not have voting rights unless :

  1. their dividend are in arrear, or
  2. their interests are affected.

Types of Preference Shares

  1. Participative and Non- participative Preference Shares:

    Ordinarily preference shares are non- participative. They are participative only when so described, otherwise not. Participative preference shareholders have a further right to dividend after dividend at a certain rate has been paid on equity shares. On the other hand, non- participative preference shareholders do not have any right to further dividend except the fixed rate of dividend payable on such shares.

  2. Cumulative and Non- cumulative Preference Shares:

    In case of cumulative preference shares, if in any particular year company is not able to pay dividend, it will accumulate, i.e. arrears of dividend will be paid in further years. On the other hand, in case of non-cumulative preference shares such arrears of dividend will, not be payable.

  3. Redeemable Preference Shares:

    Redeemable preference shares are redeemable after a maximum period of 20 years. Under the Companies Act, 1956, it is obligatory for a company to create Capital Redemption Reserve Funds so that redemption of capital is ensured. However, a company is free to redeem such shares out of the proceeds of fresh issue of preference shares.

  4. Convertible and Non-convertible debentures:

    Holders of convertible preference shares have a right to get their preference shares converted into equity shares within a certain period. On the other hand, holders of non- convertible preference shares do not have such a right. All preference shares are non- convertible unless stated otherwise.

Merits of Preference Shares from the point of view of the company

Preference shares have the following advantages:

  1. The company can get the benefit of trading on equity.
  2. It is not required to give any security for issuing preference shares.
  3. Preference shareholders cannot interfere in the management of the company.
  4. Dividend on preference shares is payable at a fixed rate which is usually very low.
  5. Company can raise capital by issue of preference shares even during the depression period, when nobody is willing to invest in equity shares.
  6. Cost of issuing preference shares is comparatively lower than the cost of issuing equity shares.

Merits of Preference Shares from the point of view of the preference shareholders

  1. Holders of such shares get an assured or fixed rate of return on their investment.
  2. They have a preferential right to get dividend before any dividend is paid to the equity shareholders.
  3. They have a priority for refund of capital in case the company goes into liquidation.
  4. These shares are redeemable within a fixed period (maximum within 20 years of issue).
  5. In case of cumulative preference shares arrears of dividend are payable in future years.
  6. In case of participative preference shares, they have a right to share surplus profit after dividend at a certain rate has been paid to the equity shareholders.

Limitations of Preference Shares

Although preference shares have so many advantages, yet these suffer from the following drawbacks;

Limitations from the point of view of the company
  1. Company has to pay arrears of dividend in future years if the preference shares are cumulative.
  2. Company has to make provision for return of capital because such shares are redeemable within 20 years. The company is under a legal obligation to create Capital Redemption Reserve Fund to make provision for redemption of preference shares.
  3. Preference shareholders can interfere in the management if their dividends are in arrear or if their interests are affected.
  4. It is not permanent capital of the company.
  5. Cost of raising funds through the issue of preference shares is higher than the cost of borrowing funds from other sources.
Limitations from the point of view of preference shareholders
  1. Investor gets a fixed and a low return on his investment.
  2. Investor cannot enjoy the benefit of higher returns if there are good profits.
  3. Investor has no right to interfere in the management as he has no voting right except when his dividend is in arrear or his interests are likely to be affected by the matter to be discussed in the meeting.
  4. There is little or no chance of capital appreciation.

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