Meaning, Definition and Classification of Preference Shares

Raising capital by issue of shares is a most important method of raising long-term funds. Those funds can be invested in long-term or permanent assets like land and building, plant and machinery, furniture etc. A share is unit of measure of a shareholder's interest in the total capital of the company. Share capital of a company is divided into a large number of equal parts and each part is known is a share. According to Companies Act, a company can issue two types of shares -preference and equity.

Preference shares. Sec. 85(1) of the Companies Act defines preference shares as those shares which carry preferential rights as the payment of dividend at a fixed rate and as to repayment of capital in case of winding up of the company. Thus, both the preferential rights viz. (a) preference in payment of dividend and (b) preference in repayment of capital in case of winding up of the company, must attach to preference shares. The rate of dividend on these shares is fixed and the dividend on these shares must be paid before any dividend is paid to ordinary shares. Directors, however, may decide not to pay any dividend to any class of shareholders even if there are sufficient profits. But, if any how, they decide to pay the dividend, preference shareholders will get the priority to pay the ordinary shareholders.

Preference shares may be classified according to the rights attached to them as follows:

Cumulative and Non-cumulative Preference shares
Cumulative preference shares enjoy the right to receive the dividend in arrears for the years in which company earned no profits or insufficient profits, in the year in which company earns profits. In other words, dividend on these shares will go on accumulating until it is paid in full with arrears, before any dividend is paid on equity shareholders. In case of non-cumulative preference shares dividend does not accumulate and therefore, no arrears of dividend will be paid in the year of profits. If company does not have any profits in a year, no dividend will be paid to non-cumulative preference shareholders.

Redeemable and Irredeemable Preference Shares
Redeemable preference shares can be redeemed on or after a period fixed for redemption under the terms of issue or after giving a proper notice of redemption to preference shareholders. The companies Act, however, imposes certain restrictions for the redemption of preference shares. Irredeemable preference shares are those shares which cannot be redeemed during the lifetime of the company.

Convertible and Non-convertible preference shares
Where the preference shareholders are given a right to covert their holding into ordinary shares, within a specified period of time, such shares as known as convertible preference shares. The holders of non-convertible preference shares have no such right of conversion.

Participating and Non-participating Preference Shares
The holders of participating preference shares have a right to participate in the surplus profits of the company remained after paying dividend to the ordinary shareholders and preference shareholders at a fixed rate. The preference shares which do not have such right to participate in surplus profits, are known as non-participating preference shares.

The advantages of Preference shares are as follows:

(A) Advantages from Company point of view:

The company has the following advantages by issue of preference shares.

I. Fixed Return: The dividend payable on preference shares is fixed that is usually lower than that payable on equity shares. Thus they help the company in maximizing the profits available for dividend to equity shareholders.

II. No Voting Right: Preference shareholders have no voting right on matters not directly affecting their right hence promoters or management can retain control over the affairs of the company.

III. Flexibility in Capital Structure: The company can maintain flexibility in its capital structure by issuing redeemable preference shares as they can be redeemed under terms of issue.

IV. No Burden on Finance: Issue of preference shares does not prove a burden on the finance of the company because dividends are paid only if profits are available otherwise no dividend.

V. No Charge on Assets: No-payment of dividend on preference shares does not create a charge on the assets of the company as is in the case of debentures.

VI. Widens Capital Market: The issue of preference shares widens the scope of capital market as they provide the safety to the investors as well as a fixed rate of return. If company does not issue preference shares, it will not be able to attract the capital from such moderate type of investors.

(B) Advantages from Investors point of view:

Investors in preference shares have the following advantages:

I. Regular Fixed Income: Investors in cumulative preference shares get a fixed rate of dividend on preference share regularly even if there is no profit. Arrears of dividend, if any, is paid in the year's) of profits.

II. Preferential Rights: Preference shares carry preferential right as regard to payment of dividend and preferential as regards repayment of capital in case of winding up of company. Thus they enjoy the minimum risk.

III. Voting Right for Safety of Interest: Preference shareholders are given voting rights in matters directly affecting their interest. It means, their interest is safeguarded.

IV. Lesser Capital Losses: As the preference shareholders enjoy the preferential right of repayment of their capital in case of winding up of company, it saves them from capital losses.

V. Fair Security: Preference share are fair securities for the shareholders during depression periods when the profits of the company are down.

The Disadvantages of Preference Shares are as follows:

The important disadvantages of the issue of preference shares are as below:

(A) Demerits for companies:

The following disadvantages to the issuing company are associated with the issue of preference shares.

I. Higher Rate of Dividend: Company is to pay higher dividend on these shares than the prevailing rate of interest on debentures of bonds. Thus, it usually increases the cost of capital for the company.

II. Financial Burden: Most of the preference shares are issued cumulative which means that all the arrears of preference dividend must be paid before anything can be paid to equity shareholders. The company is under an obligation to pay dividend on such shares. It thus, reduces the profits for equity shareholders.

III. Dilution of Claim over Assets: The issue of preference shares involves dilution of equity shareholders claim over the assets of the company because preference shareholders have the preferential right on the assets of the company in case of winding up.

IV. Adverse effect on credit-worthiness: The credit worthiness of the company is seriously affected by the issue of preference shares. The creditors may anticipate that the continuance of dividend on preference shares and suspension of dividend on equity capital may depreive them of the chance of getting back their principal in  full in the event of dissolution of the company, because preference capital has the preference right over the assets of the company.

V. Tax disadvantage: The taxable income is not reduced by the amount of preference dividend while in case of debentures or bonds, the interest paid to them is deductible in full.

(B) Demerits for Investors:

Main disadvantages of preference shares to investors are:

I. No Voting Right: The preference shareholders do not enjoy any voting right except in matters directed affecting their interest.

II. Fixed Income: The dividend on preference shares other than participating preference shares is fixed even if the company earns higher profits.

III. No claim over surplus: The preferential shareholders have no claim over the surplus. They can only ask for the return of their capital investment in the company.

IV. No Guarantee of Assets: Company provides no security to the preference capital as is made in the case of debentures. Thus their interests are not protected by the assets of the company.