Introduction to Preference Shares

Preference shares, often referred to as preference stocks, are a type of hybrid security that combines the characteristics of both debt and equity. They are issued by companies to raise capital and are designed to provide stability and predictable income to investors. This article delves into the advantages and disadvantages of preference shares, providing insight for investors considering this form of investment.

Advantages of Preference Shares

1. Fixed Dividend

One of the most significant advantages of preference shares is the fixed dividend rate. Unlike common shares, the dividend on preference shares is predetermined and guaranteed, making it a form of fixed income security. This predictability is crucial for investors seeking stable income. Companies typically issue preference shares to attract investors who are looking for reliable returns, often termed as 'income seekers' or 'fixed income investors'.

To illustrate, the dividend rate is usually expressed as a percentage of the nominal value of the share, which results in a fixed amount of income for the investor.

2. Cumulative Dividends

The cumulative feature of preference shares is another important advantage. This feature ensures that if the company does not earn enough profit to pay dividends in certain years, these unpaid dividends will accumulate and must be paid before dividends can be distributed to other shareholders in subsequent years. This advantage offers a secure income stream for preference share holders and adds a layer of protection in case of financial difficulties for the company.

For instance, if a company has declared a dividend but subsequently lacks the necessary profits, the unpaid dividend will accumulate and must be paid to preference shareholders in the future. This feature ensures that preference shareholders receive their due dividends over time, even if the company is not currently profitable.

3. Redemption

Another advantage of preference shares is redemption. Preference shares can be redeemed, or repaid, after a specific period, except in the case of irredeemable preference shares. This means that shareholders can expect a return of their initial investment, providing a sense of financial security. The redemption process is typically detailed in the company's articles of association, ensuring a transparent and predictable repayment timeline.

4. Participation

Participation is another key feature of certain preference shares. These shares allow shareholders to participate in surplus profits after dividends have been distributed to common shareholders. This feature can be appealing for investors seeking additional potential for higher returns, although it often comes with limitations and specific conditions. Participation rights vary widely among different types of preference shares, and investors should understand these terms carefully.

5. Convertibility

Convertible preference shares can be converted into equity shares under the terms specified in the company's articles of association. This feature provides preference shareholders with the option to convert their shares into equity, potentially benefiting from growth in the company's stock value. This convertibility feature can be particularly attractive to investors who are interested in both current income and the potential for capital gains.

Disadvantages of Preference Shares

1. Cost of Financing

The cost of preference shares is often higher compared to equity shares. This high cost of financing can be a drawback for companies seeking to raise capital, especially if they are looking for cheaper sources of funds. The additional costs associated with preference shares may reduce the overall profitability of the company and could impact long-term financial planning.

2. Lack of Voting Rights

One of the key drawbacks of preference shares is the absence of voting rights. Preference share holders do not have the ability to participate in the management of the company or make decisions regarding important corporate actions. This limits their influence and control over the company's direction, which is a significant downside for investors who prefer a voice in company governance.

3. Fixed Dividend Only

While preference shares offer a fixed dividend, they do not always benefit from additional profits generated by the company. In years where the company experiences growth and higher earnings, preference share holders may not see additional dividend increases. This fixed dividend nature can be a limitation compared to the potential for higher dividends from equity shares, especially as a company's profits expand over time.

4. Permanent Burden (Cumulative Dividends)

Cumulative preference shares can become a permanent burden in the context of dividend payments. If the company falls into unprofitable periods, preference share holders will still expect dividends to be paid. This ongoing financial obligation may lead to higher costs for the company, potentially impacting its liquidity and financial flexibility.

5. Taxation Issues

From a taxation perspective, the dividends received from preference shares are generally not deductible expenses for the company. While interest expenses may be deductible, the lack of tax benefits associated with preference share dividends can reduce the overall return on investment. This tax disadvantage is particularly relevant for companies that focus on tax efficiency and cost management.

Conclusion

Preference shares offer a blend of debt and equity characteristics, making them a valuable investment for those seeking stable, predictable income. However, they also carry certain disadvantages, such as high financing costs, lack of voting rights, and potential permanent financial obligations. Investors should carefully assess these factors and their investment goals before deciding to invest in preference shares.