Preferred Shares and Preference Dividends – A Company issues two types or classes of shares – Common Shares and Preferred Shares. Common or Equity share represents ownership in a Company. Holders of Common share may or may not be entitled to dividend, depending upon the profitability of the Company. On the other hand, preference share entitles its holders to a fixed dividend irrespective of the profitability of the Company. Dividends received on the preferred stock are known as preferred dividend.
In this guide, we discuss Preferred Shares and Preferred Dividends in depth.
- Returns through Dividends & Capital Appreciation
- Preferred Shares and Preferred Dividends – meaning?
- Preferred dividends and yield ratio – Calculation
- Common features of preferred dividend
- Types of Preference Shares
- Is preferred share equity or debt?
- Users of Preferred shares
- Advantages of Preferred dividend
Returns through Dividends & Capital Appreciation
The objective of every investor while making an investment is to get returns out of an investment. While there are countless number of financial instruments like equity shares, preference shares, bonds and etc in the financial market, there are only two types of returns that every investor earns while making investment in any of the above mentioned financial instruments – Dividends and Capital appreciation.
Let’s understand it with the help of an illustration
If Mr. X bought equity share of XYZ Inc. at a market price of $50 in 2005, and sold those share in the market in 2015 at prevailing market price of $100, after receiving annual dividend of $5 every year for 10 years.
Then the total return received by Mr. X will comprise of the same two components – Dividends and Capital appreciation.
Total dividend received by Mr X. = $50($5 * 10)
Capital appreciation = $50($100 – $50) (Sold value of investments – Initial value of investments)
Return on every instrument be it equity, preference or debt will comprise of only these two components.
A Company issues two types or classes of shares – Common and Preferred. Common or Equity share represents ownership in a Company. Holders of Common share may or may not be entitled to dividend, depending upon the profitability of the Company. On the other hand, preference share entitles its holders to a fixed dividend irrespective of the profitability of the Company. Dividends received on the preferred stock are known as preferred dividend. They are known as preferred because in case a Company is unable to pay all dividends, claims to preferred dividends will take precedence over claims to dividends paid on equity shares.
source: Diana Shipping
Preferred dividends and yield ratio – Calculation
Let’s understand the calculation of preferred dividend with the help of illustration
Mr. X owns 20,000, 10 percent preferred shares which were issued at a par value of $50 per share. Currently stock is trading at NYSE at $60, then:
Preferred Dividend Calculation
The dividend per share of preferred shares = $50 * 10% = $5
Total Preferred Dividends = 10,000 shares * $50 * 6.5% = $32,500
For calculation of preferred dividend, multiply the par value or issue value of the preferred shares by the dividend percentage. Dividend percentage is stated in prospectus of the preferred shares. Alternatively, percentage is also stated in the share certificate issued by the Company.
Preferred Dividend Yield Calculation
Dividend yield ratio = 5/60* 100% = 8.33%
Yield is the effective interest rate that a person receives if he holds the share of one year. Formula for calculation of dividend yield ratio is,
Dividend per Share / Market Price per Share * 100%
Common features of preferred dividend
#1 – Higher dividend rates
- Preferred dividend rates are much higher than the rates of equity or common stock.
- The reason for this is because preference shareholders do not have ownership control over the company, hence to attract the investors, higher rates of dividends are offered to them.
#2 – Fixed percentage
- Unlike the dividend on common or equity stock which keeps on fluctuating every year depending on the profitability of the company, preferred dividends do not fluctuate, their rate remains unchanged throughout the maturity life of preference share.
- There is also one other major reason for fluctuation of dividend on common stock.
- Dividend rates on common shares are recommended by the shareholders during the annual general meeting of the company.
- Hence it keeps on fluctuating since the shareholders decide rates keeping in mind the profitability and future outlook of the Company.
#3 – Cumulative or arrears in dividend
- One of the important features of the preferred dividends is that shareholders are entitled to preferred dividend every year irrespective of the profitability of the Company.
- But sometimes, on account of business exigencies, company may not be in a position to pay to shareholders.
- In such circumstances dividends are accumulated and are paid in subsequent year.
- Let’s understand the impact of one of the business exigencies on payment of preference dividend with the help of practical illustration.
Cumulative Preferred Dividend Example
Company X Inc. has 3 million outstanding 5% preferred shares as on December 31st 2016. Par value of preference shares are $10 each. Cash balance available with Company is $1 million.
Preference dividend to be paid for the year 2015 = 1,500,000 (3,000,000 *10*5)/100
Available cash balance =1,000,000
In the above case, it’s not possible for the company to pay preferred dividend to shareholders since the total available cash is less than the total amount of preferred dividend liability. Since dividend are always paid in cash, its shortage, will force the company to withhold the payments of dividend for the year 2016. In the above case, dividend will get accumulated and must eventually be paid to preferred shareholders in subsequent financial year.
Please note, that the above illustration highlights just one single business exigency. There are various other business exigencies which might force the company to withhold the payment of preferred dividend.
#4 – Legal obligations
- Preferred dividends, like interest on debts, create legal obligation on the company. These are to be paid to shareholders in preference over any common stock dividend.
- The liability on the company to pay preferred dividends is unconditional and absolute.
- Various jurisdictions impose penalties in case company does not pay outstanding preferred dividend.
- These penalties ranges from fine and imprisonment of directors to prohibition on the company to raise additional finances from the public, till the liabilities are paid out.
#5 – Preferred treatment
- Preferred dividend are paid out to shareholders in precedence over other types of dividends i.e. dividends are paid out to shareholders before common stock or equity dividends are issued.
- In case of liquidation of company, the shareholders with preferred shares are entitled to be paid from company assets first.
- All this feature of the preferred dividend gives it the preferential treatment with respect to other types of dividends.
- The above features highlight some of the common features contained in the most of the preferred shares. In the corporate world, there are various types of preference shares.
- These may or may not have some of the above mentioned features and may also contain some additional unique features.
- Now, let’s looks at the different types of preference shares that are issued by the company to raise capital in primary and secondary market.
Types of Preference Shares
Cumulative preferred Shares
In cumulative preferred shares, preferred dividend always gets accumulated for subsequent years. Such type of preferred shares includes provision, where in, company is required to pay all dividends – Present as well as past, in subsequent years.
source: Hanesbrands Inc
Non-Cumulative preferred shares
In case of non cumulative preferred shares there are no legal obligation on the company to pay past accumulated dividends. If a company does not pay dividends on account of business exigency or otherwise, shareholders have no right to claim unpaid dividend in the future.
Convertible preferred shares
This type of shares gives it holders a legal right but not an obligation to exchange for a predetermined number of company’s equity or common stock. Conversion may occur at a predetermined time or at any time the investor chooses. Conversion occurs at an exercise price, which is always a predetermined price. This type of preferred shares provides its holder to participate in the equity shares by way of conversion.
Participating preferred shares
It provides shareholders an opportunity to receive additional dividends apart from normal regular dividends. Additional dividends are paid by the company on achieving certain predetermined milestones like achieving certain amount of revenue, net profit or some other benchmarks. Shareholders continue to receive their regular dividend regardless of company achieving predetermined milestone.
Perpetual preferred shares
These type of preferred shares do not have any maturity period. In case of perpetual preferred shares, initial invested capital is never returned to the shareholders. Shareholders continue to receive preferred dividend for infinite period. Most of preferred shares falls into this category.
source: General Finance
Prior preferred shares
Company generally issues more than one type of preference shares i.e. they may issue convertible, non-convertible, participating and etc. Any preferred share which is designated as prior preferred stock by the company will have prior claim on dividends over other types of preference stock. Therefore, it can be said that prior preferred have less credit risk than other preferred stocks. Let’s understand this with the help of simple illustration.
Prior Preferred Share Example
Company X Inc. has following outstanding preference shares.
6% Series X perpetual preferred shares – 5 mn
6% Series Z Prior preferred shares – 5 mn
Available cash 300,000
In the above case, dividend will be paid as follows.
Dividend to be paid on Series x = $300,000 (5mn * 6%)
Dividend to be paid on Series z = $300,000 (5mn * 6%)
Total dividend to be paid = $600,000
Available cash = $300,000
Since in the above case there is shortage of available cash for payment of total dividend liability, hence only dividend up to $300,000 will be paid to the shareholders. Payment will not be distributed amongst series x and z on proportionate basis. But the entire payment will be made to series Z, prior preferred shares, since such shares will always have prior claim on dividends over other types of preference shares.
The above list comprises of the most of the type of preference share issued by the company in the primary and secondary market. In the corporate world, there are various other types of preference shares.
Is preferred Share equity or debt?
Preferred shares is a hybrid security sharing some features of debt instrument and some of equity.
Equity features of Preferred shares
Like equity, it has perpetual life i.e. infinite life. In the financial statement, it shown under shareholder equity section, not the debt column. While interest payment on debt are tax deductible, preferred dividends are not tax deductible.
Debt features of Preferred shares
Like debt, preferred shares has a fixed dividend payout as stock carries fixed dividend rate. In fact, investing in preferred shares is more like investing in a debt instrument rather than equity, since almost all the returns comes out in form of dividends.
- As it can be seen from the above stated facts, preferred shares exhibits the features of both equity and debt, hence classification of preferred shares under debt or equity would depend upon the type and nature of preferred stock.
- Perpetual and cumulative preferred stock can easily be classified as debt instrument since dividends received from them are fixed and invested capital never gets refunded on account of their infinite time period.
- Whereas, non-cumulative and convertible preferred shares are classified as equity.
- Hence, it can be said that the type of preferred shares plays an important role with respect to classification of preferred shares.
Users of Preferred Shares
- Cost of preference share is more than the cost of debt but less than the cost of equity instrument. The reason is simple; cost depends upon the riskiness associated with the instrument.
- Amongst all the three instrument mentioned above, the financial risk in holding an equity stock is far greater due to tax advantages of interest payments and uncertainties associated with its dividend payment.
- On the other hand, cost of preference is greater than cost of debt on account of the tax advantages of interest payments.
- Despite it being costlier than the debt, it is preferred by large number companies for raising additional capital.
- Among US companies, the biggest issuers of preferred shares are the financial service companies (banks, insurance companies) and there is a simple reason for it.
- While it may be more expensive than conventional debt, it is counted as equity by the regulatory authorities while computing capital ratios for banks.
Advantages of Preferred dividend
Some of the common advantages of the preferred dividend are highlighted below -:
- Higher dividend rate – This is one of the most important advantage of holding preference shares. Amongst all the debt instruments like bonds, commercial papers, Government treasury bills and etc., return received by an investor by holding a preference share is far greater than received through holding any other debts instrument. The reason is pretty obvious, since cost is directly related to return. Higher the cost of holding any instrument, higher is the return received through it and vice versa.
- Preferential treatment – As highlighted above, preferred shareholders have right to preferential treatment regarding dividends. In the event of liquidation of Company, the shareholders with preferred shares are entitled to be paid from company assets prior to Common stock shareholders.
- Assured minimum return – Preference shares have a fixed dividend rate, whereas on the other hand common stocks do not have fixed dividend. Fixation of dividend rate in advance guarantees the minimum return to shareholders. Shareholders do not have to depend on the general economic conditions or the profitability of the company. In case the company suffers loss, dividend get accumulated for subsequent year.
Over the years, preferred shares have become quite popular instrument used by the corporates for raising capital. Preferred shares combines features of both types of instrument – Debt and Equity. Though preferred dividend payment depends upon number of factors such as availability of cash, profitability of company. But the shareholders right to receive is absolute and is not affected by above factors. In case of shortage of funds, it is paid at a later date. All this factors have contributed to the growing popularity of the preferred shares over the other forms of investments.