PREFERENTIAL SHARES: ADVANTAGES AND DISADVANTAGES

Companies seek investments through Shares, and shares are divided broadly into two categories,
Equity shares and preferential shares. Preferential shares are termed a hybrid form of source of
raising capital, as they have very peculiar advantages and disadvantages; broadly the most
important advantage from the perspective of the Company is that the Company doesn’t have to
compromise on control or the decision making of the Company, and there is no legal obligation
on the Company to pay dividends. The various types of preferential shares are Cumulative
preference shares, non-cumulative preference shares, redeemable preference shares,
irredeemable preference shares, convertible preference shares and non-convertible preference
shares. Each of this type of preferential shares has their own features, and advantages; however
this article discusses the aspects broadly from the perspective of preferential shares.

The advantages of preferential shares from the perspective of the Company are –

No issue of voting rights

The primary advantage attached with preferential shares is that they do not carry voting rights,
therefore, the control of the equity shareholders in the Company is not decreased, and the Equity
shareholders still have the major decision making power in the Company. E.g. X has 1000
preference shares in Company Y; he has no stake in the management or control of the Company,
whereas if Z has 10 equity shares in Company Y, then he has control/stake in the management of
Company

No obligation to pay dividends

Unlike, Equity shares it is not a legal obligation of the Company to pay dividends to preferential
shareholders, it is at the discretion of the Company to pay profits. A Company is not declared
bankrupt if the Company is unable to pay dividends to the preferential shareholder, which is the
case for Equity shares; therefore, they are safer way of raising finance for the Company.

Long term capital

Preferential shares are generally invested by investors as a source of long term investment, and
serve as a source of raising finance for a longer time period, as generally equity shares are traded
for shorter time periods.
Help in maintaining equity debt ratio

Preferential shares increase the financial strength of the Company, therefore, they diminish the
need for a Company to accumulate or raise capital through debt. The advantage of this is that the
Company doesn’t have to use its assets as collateral, and more importantly it doesn’t have to pay
the high rates of interest. E.g if Company has 10 lakh capital in equity, and 4 lakh in Debt, then
the Company can issue preferential shares to increase the proportion of equity, and maintain the
proportion of debt and equity in the Company.

The advantages of preferential shares from the perspective of the Shareholder are:

Preferential rights in repayment of Dividends

As the name, preferential suggests, these shareholders have preferential rights, they have a first
claim in the profits of the Company, moreover, at the time of liquidation, preferential
shareholders are to be paid back first. It is only after repayment of preferential shares, that
payment can be made to the Equity Shareholders. E.g. X has 100 preferential shares in
Company Z, and Y has 200 Equity shares in the same Company, during liquidation the
preferential shareholders are to be repaid first, and it is only after repayment made to X, and
other such shareholders, that payment can be made to Y and other equity shareholders.

No volatility

Preferential shareholders get a fixed rate of dividends, unlike equity shareholders, whose return
of investment is hinged on the doings of the Company in the shareholder. Therefore, they are
safer forms of investment. E.g. X has 10 shares in Company Y, and then his rate of Dividend is
pre decided and cannot be changed.

Control

Inspite of the fact that it is a primary feature of preferential shares that they don’t have voting
rights, Section 87 of the Companies Act provides that preferential shareholders have voting
rights regarding decisions which directly affect the preferential shareholders. Thus even
preferential shareholders have control in the Company regarding decisions which directly affect
the, hence they are protected from arbitrary or rash decisions taken them through resolutions by
the Company.
Higher returns than Debentures

The returns from preferential shares is higher than debentures, therefore, they are a better source
of hybrid investments for investors who want affixed rate of returns, as they don’t want to take
much risk, yet they want higher rates of dividend. Thus these shares are a better source of
investment for cautious investors, who would have otherwise sought to invest in Debentures

DISADVANTAGES OF PREFERENCE SHARES

Allotment of Preferential shares proves to a great deal and return high fixed dividends. However,
if the situation of the company gets worse, preferential shareholders gets preference over
common stockholders to get their money back. But these shares are usually issued by the
companies not to the individuals but to the institutions. Moreover, preference shares are not
traded on the markets like equity shares are done. There are also some disadvantages of this
investment option which are discussed below.

Disadvantages in respect of Investors

Disadvantage of not having variable dividends

Preferential shareholders have the disadvantage of having static rate of dividends which gets
usually decided at the time of sale and stays till the time stock gets matured. However, the rate of
dividends is usually higher than the prevailing bond interest rates but it becomes a disadvantage
to the investor if the rates goes up than the decided rate which usually fluctuates within the
market.

For e.g. Company X issues the preference shares at the rate of 6% for the dividend. But the
business of the company grows and the rate of dividend for the equity shareholders becomes 8%
in 4 years. This make preference shareholders in a loss as the dividend for preferential
shareholders will remain static.

Value of the preferential shares increases in a limited way

Preferential shares usually have a steady price which made the investor lack from deriving
profits from the sale of shares which common stockholders gets. Moreover, in case the interest
rates increased, there is always a risk of decrease in the price of shares. Investors will be willing
to pay for higher yielding bonds rather than the shares of low dividend rates.

Voting Rights

Voting rights are not provided to the preferential shareholders in the personal matters of the
company which lacks their control over the company. Therefore, there is not sort of interference
from the preference shareholders over the matter of company. Equity shareholders has voting
rights over the matters of the company. For e. Company law obligates special resolution at the
time of winding up but the preferential shareholders are not allowed to have a say as they don’t
have voting rights.

Preference shares don’t attract

Investors generally do not wish to spend on preferential shares over government securities and
debentures. If a company wants to attract investors, it needs to offer a higher rate of dividends.

Callable Preference Shares

Company has the power to issue callable preference shares which provides the companies with
the right to callback the shares on the discretion. This types of shares area disadvantage to the
shareholders as the company can call-back at any time. For e.g. a company issues the preference
shares at the rate of 6% and call them back when the interest rates fall to 4% and them reissue the
shares with a lower dividend rate, thereby reducing the cost of capital. It also effects company’s
debt-equity ratio.

Disadvantage in respect of company

Dividends rates are high

The company has to pay preferential shareholders a higher rate of dividends than the common
stockholders while the issuance of shares which increases the cost of the company. This
advantage to the preference shareholder become a disadvantage to the company at the time of
winding up also as the preferential shareholders will get preferential rights to get their money
back at the time of winding up. For e.g Company X issues preferential shares at the rate of 6%
and issues equity shares at the rate of 5%. Investor will not prefer preferential shares as there is
not much difference in dividends and the rights are much in equity shares. That’s why
preferential shares need to have a high dividend rate at the time of issuance.

Tax Disadvantages

Company did not get any deduction in income tax for providing preferential rights to the
preference shareholders which is present in the case of interest paid to the debenture or bond
holders. This also makes the issuance of preference shares as a costly source of finance. For
example, interest rate on debt is 10% and dividend rate on preferential shares is 9% and the
prevailing tax on debt is 50%. Therefore, the effective cost of preference shares is same i.e.9%
but that of debt is 5%{10% * (1-50%)}.

Financial burden gets increased

The issuance of preference shares is done cumulatively which increases the financial burden over
the company. It means that the company is obligated to pay the arrears of preference dividend
before paying dividend to the equity shareholders. In consequence, it reduces the profits of
equity shareholders.

Effect on credit worthiness

This is because preferential shareholders gets preferential rights over the assets of the company.
The credit worthiness gets affected because there is always an apprehension by equity
shareholders of not getting back their principal amount at the time of winding up due to the
preferential rights of preferential shareholders over dividends.