A preferred share is a share that enjoys priority in receiving dividends as compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights; however, their claims are discharged before the claims of common stockholders at the time of liquidation.
A preference share entitles its holders to a fixed dividend irrespective of the company's profitability. Dividends received on the preferred stock are known as preferred dividends. They are preferred because if a company cannot pay all dividends, claims to preferred dividends will precede claims to dividends paid on equity shares.
Preferred shares are entitled to receive dividends prior to common shares. The dividend rate on preferred shares can either be fixed or variable, depending on the terms of issuance.
Preferred shareholders typically lack voting rights, yet they hold priority in receiving payments before common shareholders in case of liquidation.
Preferred shares can be categorized into various types, including cumulative preference shares, non-cumulative preference shares, convertible preference shares, participating preference shares, perpetual preference shares, and prior preference shares.
Preference shares entail costs higher than debt but lower than equity instruments.
How Do Preferred Share Work?
Preferred shares are a type of ownership in any company. The owners of such a stock gets some rights and privileges that common stockholders do not get. They are very often considered to be financial instruments that are hybrid in nature, meaning they have the features of both equity and debt. However, they have some stability as compared to equity or common shares but offer a steady strem of dividend income.
The terms and conditions of this kind of shares will depend on the rules and structure of the business and terms and condition of share issue. Over the years, preferred shares of stock have become quite a popular instrument used by corporations for raising capital. Preferred shares combine features of both types of an instrument – Debt and Equity. However, preferred dividend payment depends upon several factors, such as the availability of cash and the company's profitability. But the shareholder’s right to receive is absolute and is not affected by the above factors. In case of a shortage of funds, it is paid later. All these factors have contributed to its growing popularity over the other forms of investments.
These shares not only get a priority right over dividend distribution, but also during receiving claims during liquidation or bankruptcy. In case the business is under severe financial distress and needs to be sold off or liquidated, then the owners of preference shares have a priority over the assets sold and claim their share from the proceeds. However, the preferred shares list also have their own limitations in terms of capital appreciation or voting rights in the company.
Dividends Calculation
Let’s understand the calculation of preferred shares dividends 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, the stock is trading on NYSE at $60 then:
Preferred Dividend Calculation
The dividend per share of preferred shares = $50 * 10% = $5
To calculate the preferred dividend, multiply the preferred shares' par value or issue value by the dividend percentage. The dividend percentage is stated in the prospectus. Alternatively, the percentage is also stated in the share certificate issued by the company.
Yield is the effective interest rate a person receives if he holds the share for one year. The formula for calculation of dividend yield ratio is,
Dividend per Share / Market Price per Share * 100%
Types
#1 - Cumulative Preference Shares
In cumulative preferred shares, the preferred dividend accumulates for subsequent years. Such type includes the provision wherein the company is required to pay all dividends – Present and past- in subsequent years.
In the case of non-cumulative preferred shares of stock, the company has no legal obligation to pay past accumulated dividends. If a company does not pay dividends on business necessity or otherwise, shareholders have no right to claim unpaid dividends in the future.
Convertible preferred shares are a type of share that gives its holders a legal right but not an obligation to exchange for a predetermined number of a company's equity or common stock. It allows the holder to participate in the equity shares by conversion. Conversion may occur at a predetermined time or any time the investor chooses. Conversion occurs at an exercise price, which is always a predetermined price.
The company pays additional dividends on achieving certain predetermined milestones like achieving certain amounts of revenue, net profit, or some other benchmarks. It allows shareholders to receive additional dividends apart from normal regular dividends. Shareholders continue to receive their regular dividend regardless of a company achieving a predetermined milestone.
source: Autodesk
#5 - Perpetual Preference shares
These types do not have any maturity period. In the case of perpetual preferred shares, the initial invested capital is never returned to the shareholders. Shareholders continue to receive a preferred dividend for an infinite period. Most of the preferred shares fall into this category.
source: General Finance
#6 - Prior Preference shares
The company generally issues more than one type, i.e., they may issue convertible, non-convertible, participating, etc. Any preferred share, designated as prior preferred stock by the company, will have a prior claim on dividends over other types of preference stock. Therefore, it can be said that prior preferred stocks have less credit risk than other preferred stocks. Let’s understand this with the help of a simple illustration.
Prior Preferred Share Example
Company X Inc. has the 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, the 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
In the above case, there is a shortage of available cash to pay the total dividend liability. Hence only a dividend of up to $300,000 will be paid to the shareholders. Payment will not be distributed amongst series x and z proportionately. But the entire payment will be made to series Z, prior preference shares, since such shares will always have a prior claim on dividends over other types of shares.
The above list comprises most of the types issued by the company in the primary and secondary markets.
Is Preferred Share Equity Or Debt?
Preferred shares are hybrid security sharing some features of a debt instrument and some of the equity.
Equity features
Like equity, it has a perpetual life, i.e., infinite life.The financial statement is shown under the shareholder equity section, not the debt column. While interest payments on debt are tax-deductible, preferred dividends are not tax-deductible.
Debt features
Like debt, preference shares have a fixed dividend payout as stock carries a fixed dividend rate. Investing in such shares is more like investing in a debt instrument than equity since almost all the returns come from dividends.
As can be seen from the above-stated facts, such shares exhibit the features of both equity and debt. Hence the classification of preference 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 instruments. The dividends received from them are fixed, and invested capital never gets refunded because of their infinite period.
Whereas non-cumulative and convertible preference shares are classified as equity;
Hence, it can be said that the type of preferred shares plays an important role in its classification.
Users of Preferred Shares
The cost of preference share is more than the cost of debt but less than the equity instrument. The reason is simple; the cost depends upon the riskiness associated with the instrument.
Amongst the three instruments mentioned above, the financial risk in holding an equity stock is far greater due to thetax advantages of interest payments and uncertainties associated with its dividend payment.
On the other hand, the cost of preference is greater than the cost of debt on account of the tax advantages of interest payments.
Despite being costlier than the debt, it is preferred by many companies to raise 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.
Preferred Shares Vs Common Shares
A Company issues two types or classes of shares – Common and Preferred. Both preferred and common or Equity share represents ownership in a Company. But each of them have their own rights, rules and characteristics. Let us compare them and find out the differences.
Holders of Common shares may or may not be entitled to the dividend, depending upon the company’s profitability. On the other hand, preferred shares typically get a fixed amount of dividend from the company which is a percentage of the share’s face value.
The former has a priority in receiving the preferred shares dividends. The get paid before the common shareholders. Even if the company is facing any financial crunch, the former will get the dividend first.
In case of voting rights too, the procedure is not the same for both. However, in this case the latter actually possess the voting right for and company and management decision like election of board of directors. The former has either very limited or no voting rights at all in company decisions.
In case of liquidation, the former has a preference to get their claims from the proceeds. They get their share from the assets remaining before common shareholders.
In terms of stability regarding income stream, preferred shares are a better choice. Investors prefer them because they provide fixed and regular dividends.
Sometimes the company may issue callable preferred shares in which the company has the right to call back the shares or redeem them after a certain period and at a certain price. This type of option offers a kind of flexibility to the business because they can repurchase the stocks as and when needed.
The former also offers some of its shareholders the option to convert their preference shares into common stocks, that are called convertible preferred shares, which is not the case in case of common stockholders. They cannot convert their common shares into preferred shares.
Unlike common shares some preference shareholders are entitled to get additional dividends which is more than the fixed amount that they normally receive in case the company is able to earn profits beyond their expectations.
Thus, the above points clearly highlight the various differences that exists between the two types of stocks that companies, issue. However, which type of share to choose and invest will depend on the financial objective of the investor, their own risk taking capacity and the level of interest and desire to participate in the company and management decisions.
What Are Preferred Shares - Debt or Equity? Video
Frequently Asked Questions (FAQs)
1. What is the difference between preferred share and common share?
Preferred shares and common shares represent distinct types of ownership in a company. Preferred shares offer certain advantages, such as priority in receiving dividends and higher claims on company assets in case of liquidation. However, preferred shareholders usually do not have voting rights. In contrast, common shares come with voting rights, allowing shareholders to participate in corporate decisions, but they generally have lower priority in dividend distribution and asset distribution during liquidation.
2. What are the benefits of preferred shares?
Preferred shares offer several benefits to investors and companies. For investors, they provide a stable stream of dividends, making them an attractive option for income-oriented investors. Preferred shareholders also have a higher claim on company assets, which can provide a degree of security. For companies, issuing preferred shares allows them to raise capital without diluting voting control, which is particularly useful in maintaining ownership stability.
3. What is a major disadvantage of preferred stock?
A significant drawback of preferred stock is its lack of potential for substantial capital appreciation. While common shareholders can benefit from a company's growth in value, preferred shareholders generally receive fixed dividends and have limited participation in the company's increased profitability.
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The article has been a guide to what are Preferred Shares. We explain their differences with common shares, dividend calculations and types.
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