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2.4. Preference shares

2.4.1. Introduction

It was seen earlier that there are only two types of shares that companies may issue, i.e. ordinary shares and preference shares (termed preferred stock in some other markets such as the US). Preference shares are covered by the company statutes of countries. In terms of redeem ability (maturity) there are three types of preferences shares:

• Compulsory maturity.

• Maturity at the option of the issuer company.

• No maturity (the perpetual preference share).

Characteristic

Ordinary shares

Preference shares

Represents ownership of company

Yes

No

Yes

Fixed periodic payment

No

Yes

Yes (usually)

Dividend payment

Yes

No

Yes

Senior risk status

No

Senior to all

Senior to ordinary shares

Voting rights

Yes

No

No*

Fixed maturity date

No

Yes

Yes & No

Can force liquidation

No

Yes

No

Convertibility option

No

Yes

Yes

*Usually not, but there are exceptions

Table 4: Preference shares: similarities to ordinary shares and bonds

One country's Companies Act, for example, provides that a:

".. .company may determine that any preference shares shall be issued on the condition that they are, or are at the option of the company, liable to be redeemed."

Preference shares have characteristics of bonds and shares, and can thus be termed hybrid securities. Their similarities / differences to shares and bonds are shown in Table 4.

The three types of preference shares in terms of maturity can have one or more characteristics which are outlined below after we describe the common preference share. The following are the sections:

• The "normal" or "common" preference share.

• The non-cumulative preference share.

• The participating preference share.

• The convertible preference share.

• Preference share hybrids.

We then conclude with a discussion of the advantages of preference shares.

BOX 2: EXAMPLE OF A PREFERENCE SHARE CERTIFICATE

EXAMPLE OF A PREFERENCE SHARE CERTIFICATE

Source: stocksearchintl .com.

2.4.2. The "normal" or "common" preference share

The typical preference share is the one that carries a fixed rate of interest, called a fixed dividend. The dividend is paid either annually or six-monthly. These preference shares are thus non-participating, and are cumulative.

Non-participating means that the preference shareholder does not receive any payments in addition to the contracted fixed dividend or participate in the profits of the company, as do ordinary shareholders.

Cumulative means that if the company does not pay the dividend, it is in arrears in this respect, i.e. it remains liable for the dividend. Clearly this dividend must be honored before payments of dividends are made to ordinary shareholders.

It is notable that some preference shares are also issued with an obligation to pay a floating dividend. In this case, the dividend is linked to some benchmark rate such as prime rate, the treasury bill rate and the call money rate (the average of a number of banks' rates).

The price / value of the fixed rate, fixed redemption date preference share is calculated according the bond pricing formula.

2.4.3. The non-cumulative preference share

Preference shares can also be non-cumulative. This simply means that passed-up dividends are not cumulated, i.e. are never paid.

2.4.4. The participating preference share

The common preference share is non-participating. Participating preference shares are where the holder participates in the profits of the company in ways other than the fixed dividend. There are essentially two types of participating preference shares:

• The shareholder receives a bonus dividend payment in the good years. The basis for this may or may not be predetermined.

• The shareholder shares in the profits as do the ordinary shareholders.

It will be apparent that participating preference shares are more expensive than the common preference shares.

2.4.5. The convertible preference share

Preference shares may also be issued with an option for conversion into other securities, but usually the shares of the company. The basis of conversion, i.e. the terms, is usually predetermined.

2.4.6. Preference share hybrids

Hybrids of the above also exist. For example, a company may decide to issue preference shares that are participating, non-cumulative and convertible.

2.4.7. Advantages of preference shares

There are a number of advantages and disadvantages pertaining to preference shares for both companies and the holders:

• Preference shares are a convenient borrowing tool in the case where companies wish to borrow for short periods (a few years) as opposed to their seeking permanent capital (ordinary shares). Obviously this only applies in the case of non-convertible preference shares.

• Companies can accumulate dividends. In difficult years, when it is not financially propitious to pay dividends, companies can miss the dividend, and have no concern of being put into liquidation (this may only be brought about by creditors). However, a passed-over dividend detracts from the image of the company; the company that misses a preference share dividend may have difficulty in raising capital thereafter.

• In many countries preference share dividends are not taxed in the hands of the holder. However, in this case companies cannot deduct preference dividends from income for tax purposes, as they may in the case of the payment of interest on bonds.

• Preference share funding is cheaper than bond issues. Because preference share dividends are not taxed in the hands of the holder the dividends (rates) payable on these instruments are lower than the rates payable on equivalent term bonds.

 
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