The capital of a company is divided into different units with a definite value called shares. The holders of these shares are called shareholders.
There are two types of shares which a company may issue, namely, preference shares and common shares.
In this article, we look at the different types of preference shares available in the Indian market.
In this article
- Types of Preference Shares in India
- 1. Cumulative Preference Shares
- 2. Non-Cumulative Preference Shares
- 3. Redeemable Preference Shares
- 4. Irredeemable Preference Shares
- 5. Participating Preference Shares
- 6. Non-Participating Preference Shares
- 7. Convertible Preference Shares
- 8. Non-Convertible Preference Shares
- 9. Preference Shares with a Callable Option
- 10. Adjustable-Rate Preference Shares
- What are Preference Shares?
A preference share is called cumulative when the outstanding payment of a dividend is cumulative.
If a company does not have the financial capability to pay a dividend to the owners of its preference shares at any point of time, then it will not pay a dividend to its common shareholders, as long as the preference shareholders are not paid.
The dividend amount gets carried on to the next year.
Suppose a company X has 10,000 preference shares @ 8% of ₹100 each. But the dividends for 2018 and 2019 have not been paid to the owners of its preference shares so far.
So now the directors before they can pay a dividend to the common shareholders for the year 2020, must pay the preference shareholders an amount of ₹2,40,000 i.e. for the year 2018, 2019 and 2020 before making any payment to the common shareholders for the year 2020.
A non-cumulative preference shareholder is only payable from each year’s net profit. A non-cumulative preference shareholder will not be paid from future profits.
So, if a company undergoes a loss in that year, then the outstanding payment of dividend cannot be claimed in subsequent years like in the case of cumulative preference shares.
A company Y normally issues a ₹70 quarterly dividend to its preferred shareholders. But the directors feel that there is not sufficient cash flow in the third quarter to pay a dividend.
As this is a non-cumulative stock, the company has no obligation to pay the missing dividend, and the holders of these shares have no claim against the company Y.
Preference shares which can be redeemed after a fixed period or after giving a certain notice are called a redeemable preference shares.
A redeemable preference share is good for the company. These act as a hedge against future inflation and when the monetary rate declines in the country.
Irredeemable preference shares are a perpetual liability, which cannot be redeemed during the lifetime of the company.
According to the Companies Amendment Act, 1988, no company can issue any preference share which is irredeemable or redeemable after 20 years from the date of the issue.
Participating preference share is where the issuing company is entitled to pay an increased dividend to the owners, in addition to preference dividend at a fixed rate,
Also, the holders of participating preference shares may have the right to share the surplus asset of the company, when it’s winding up.
Agreement for participating preferred shareholders may or may not include these features:
- If the company generates a certain amount of profit, the holder of participating preference shares will be paid a certain proportion of that profit, in addition to the normal fixed dividend.
- If the company is winding up, the participating preference shareholders will be paid a certain proportion of the net sale price received.
- Owners of participating preference shares may have the authority to approve certain actions, such as the sale of the business or larger assets associated with the business.
- Owners of these shares may have voting rights similar to common stockholders.
- These shares may be cumulative in nature so that unpaid dividends must be paid before any dividend can be issued to the owners of common stock.
An investor should buy participating preference shares when he/she believes that a company is likely to have a very strong earning.
The holders of non-participating preference shares are entitled only to a fixed rate of dividend and do not have any share in the surplus profit.
The surplus profit of the company will thus go to the common shareholders.
Preference shares are non-participating in nature unless and until expressly provided in the memorandum of the article.
Convertible preference shares are the type of preference shares where the holder has the option to convert into the common/equity share of the company.
This kind of preference share is useful for the investors who want to receive a preferred share dividend and also participate in any kind of upward change in the price of the issuer’s common shares.
So, an investor has the benefit and security of a fixed return along with a chance to earn a higher return on his/her investment.
But the convertible preference shareholders can convert into common shares within a certain period as agreed in the memorandum.
Non-convertible preference shares do not carry the right of conversion into the company’s common shares.
This is an innovative type of preference share available in the Indian capital market.
For the preference shareholders with a callable option, the issuing company has the option to buy back the share at a prefixed price on or before a pre-determined date.
For adjustable-rate preference shareholders, the rate of dividend is not fixed and depends on current interest rates in the market.
Preference shares, also known by the name preference stock, is a special type of share issued by a company having a fixed rate of dividend and which carry preferential rights over common shares in sharing of profit. They also have claimed over the asset of the company.
If the company is winding up and undergoing bankruptcy, preference shareholders are entitled to be paid from the company’s assets before common stockholders.
Also, preference shareholders typically do not hold any voting rights in the company, but common shareholders usually do.
In the Indian market, preference share evokes mixed reactions in terms of the risk-return profile and is perceived as a hybrid kind of investment.
Though technically it is a share, in terms of risk-return behavior, these are suitable for fixed income investors.
Disclaimer: The views expressed in this post are that of the author and not those of Groww