Preference shares

Preference shares

Preference shares can be a good investment option for those who want a higher priority claim on a company’s assets and earnings, but they also come with some drawbacks. Preference shareholders typically have limited voting rights, and their dividend payments may be affected if the company experiences financial difficulties. It’s important to consider the terms and conditions of preference shares before investing in them. 

What are preference shares? 

Preference shares, also known as preferred stock, provide shareholders with a higher priority claim on a company’s assets and earnings than common stockholders.  

This indicates that if a company goes bankrupt or is liquidated, preference shareholders will be paid out before common shareholders. Preference shares also often come with a fixed dividend rate, typically higher than the dividend rate paid to common shareholders. 

Understanding preference shares 

Unlike common stock, preference shares typically pay fixed dividends and have priority over common stock in the event of a company’s liquidation. However, if a company goes bankrupt, preference shareholders may still face significant losses. 

Depending on your investing goal, you should decide whether or not to purchase preference shares. These shares can be a good fit if you desire reliable returns and capital growth at lower risk over equity shares. 

Features of preference shares 

Preference shares offer several features that have allowed regular investors to outperform them even during slow economic development periods. The following list of preference share benefits is most appealing: 

  • One of the key features of preference shares is their priority in receiving dividend payments. If a company cannot pay dividends on preference and common shares, preference shareholders have priority over common shareholders in receiving dividend payments. This feature gives investors a higher level of security, ensuring they receive a consistent return on their investment. 
  • Another important feature of preference shares is their flexibility. Preference shares can be issued in different classes, each with different features such as varying dividend rates, redemption options, and conversion rights. This allows companies to tailor their preference share offerings to meet the specific needs of investors, providing them with greater flexibility and choice. 
  • Preference shares also offer investors the potential for capital appreciation. While the fixed dividend payment provides investors with a steady income stream, preference shares can also increase in value over time. This is because the market value of preference shares can rise and fall based on several factors, including changes in interest rates, market conditions, and the company’s financial performance. 
  • In conclusion, preference shares offer investors several attractive features, including priority in dividend payments, flexibility, and potential for capital appreciation. These features make them an attractive investment opportunity for investors looking for a stable income stream and a higher security level. 

Different types of preference shares 

There are several types of preference shares, each with its distinct features and benefits. Understanding the differences between the various types of preference shares can help investors make more informed decisions when investing in companies that offer these securities. 

  • Cumulative preference shares  

These types of preference shares offer shareholders the right to accumulate unpaid dividends. If a company fails to pay dividends in one year, the amount owed is carried forward to the next year, ensuring that shareholders receive their dividends eventually. 

  • Convertible preference shares  

They are another type of preference shares that offer shareholders the option to convert their shares into common shares at a predetermined conversion ratio. This can be an attractive option for investors who believe that the company’s future prospects are strong and that the value of common shares will increase. 

  • Participating preference shares  

They are a type of preference shares that offer shareholders the right to participate in the distribution of profits beyond their fixed dividend rate. If the company performs exceptionally well, shareholders may receive a higher dividend than originally agreed upon. 

  • Redeemable preference shares  

They are a type of preference shares that permit the company to buy back the shares at a specified price after a certain period. This can be a beneficial option for companies looking to raise capital in the short term, as they can offer investors the opportunity to invest in the company for a limited time. 

Example of preference shares 

Consider the situation where a fictional company ABC is issuing 8% preferred stock with a US$1,000 par value. 

A dividend of US$80 annually, or US$18.50 quarterly, would be paid to the investor in return. This preferred stock typically behaves more like a bond than a stock, trading around its par value. This security may be chosen by investors who are seeking to make money. Preferred stock can be issued to raise cash, with the financial industry being the most common issuer of this type of stock. 

Frequently Asked Questions

If a company goes bankrupt, its assets are sold, and the proceeds are used to pay off creditors. Preference shareholders have priority over common stockholders but are still subordinate to bondholders and other secured creditors. If the company’s assets are insufficient to cover all its debts, preference shareholders may not receive the full amount of their investment back. 

That said, preference shareholders may still have a better chance of recouping their investment than common stockholders. This is because preference shareholders have a higher priority in the liquidation process and are entitled to receive their dividends before common stockholders. However, it is important to note that owning preference shares does not guarantee a return on investment or protection against all risks, including the risk of bankruptcy. 

Preference shareholders get dividend payments before equity stockholders. In the event of a company’s dissolution, preference shareholders have the right to claim its assets first, making it a less risky investment than stock. 

The following risks are associated with preference shares: 

  • Interest rate risk: If the market interest rate rises, demand for these shares is expected to fall, resulting in a drop in market values. 
  • Market risk: If market conditions are unfavourable, the values of these shares may fall. 
  • Liquidation risk: Although preference shares are less liquidated than equity shares, the risk still exists. In the event of a liquidation, preference shareholders can only claim assets that remain after bondholders/debenture holders and creditors have been paid. 

Such preference shares that may be claimed after a set time or giving proper notice are known as redeemable shares. Non-redeemable preference shares are not redeemable throughout the company’s existence. They can only be retrieved after asset winding up (liquidation). 

At a fixed conversion ratio, convertible preferred shares are convertible into common stock. The preferred shareholders may wish to convert whenever the market value of the company’s ordinary stock exceeds the conversion price to make a quick profit. 

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