Preferred Shares

What are Preferred Shares?

Preferred share is the share which enjoys priority in receiving dividends as compared to common stock. The dividend rate can be fixed or floating depending upon the terms of 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 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 the 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 a 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.

Preferred Share Dividends 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, the 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 dividendCalculation Of Preferred DividendPreferred dividends refer to the amount of dividends payable on preferred stock from profits earned by the company, and preferred stockholders have priority in receiving such dividends over common stockholders.read more, multiply the par value or issue value of the preferred shares 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.

Preferred Dividend Yield Calculation

Dividend yield ratioDividend Yield RatioDividend yield ratio is the ratio of a company's current dividend to its current share price.  It represents the potential return on investment for a given stock.read more = 5/60* 100% = 8.33%

Yield is the effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more that a person receives if he holds the share of one year. The formula for calculation of dividend yield ratio is,

Dividend per Share / Market Price per Share * 100%

Top 6 Types of Preferred Shares

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For eg:
Source: Preferred Shares (wallstreetmojo.com)

#1 – Cumulative Preference Shares

In cumulative preferred shares, the preferred dividend always gets accumulated for subsequent years. Such type includes the provision, wherein the company is required to pay all dividends – Present as well as past, in subsequent years.

source: Hanesbrands Inc

#2 – Non-Cumulative Preference shares

In the case of non-cumulative preferred shares, there is 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 dividends in the future.

source: businesswire.com

#3 – Convertible Preference shares

This type of shares gives its holders a legal right but not an obligation to exchange for a predetermined number of a 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 priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more, which is always a predetermined price. It provides the holder to participate in the equity shares by way of conversion.

source: Yelp

#4 – Participating Preference 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 amounts of revenue, net profit, or some other benchmarks. 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, which is 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 have less credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more 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 for the payment of 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 on a proportionate basis. 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 type issued by the company in the primary and secondary marketsSecondary MarketsA secondary market is where securities are offered to the general public after being offered in the primary market. Such securities are usually listed on the stock exchange. A significant portion of trading happens in such a market and are of two types – equities and debt markets.read more.

Is Preferred Share equity or debt?

Preferred shares are hybrid securityHybrid SecurityHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering.read more 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. In the financial statementThe Financial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more, it 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 instrumentDebt InstrumentDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more rather than equity since almost all the returns come out in the form of 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 stockCumulative Preferred StockCumulative preferred stock is a class of shares wherein any current year's unpaid or undeclared dividends must be accumulated and paid in the future. However, such stocks are costlier, do not have voting rights and cannot demand the interim dividends.read more can easily be classified as debt instruments. The dividends received from them are fixed, and invested capital never gets refunded on account 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 with respect to its classification.

Users of Preferred Shares

• The cost of preference share is more than the cost of debt but less than the cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more instrument. The reason is simple; the cost depends upon the riskiness associated with the instrument.
• Amongst all the three instruments mentioned above, the financial risk in holding an equity stock is far greater due to tax advantagesTax AdvantagesTax Advantage are the types of investments or saving plans that benefit tax exemption, deferred tax, and other tax benefits. Examples include Government bonds, Annuities, Retirement Plans. read more of interest payments and uncertainties associated with its dividend payment.
• On the other hand, the cost of preference is greater than the cost of debtCost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more on account of the tax advantages of interest payments.
• Despite it being costlier than the debt, it is preferred by a large number of 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.

Conclusion

Over the years, preferred shares have become a quite popular instrument used by the corporates 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, the profitability of the company. 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 at a later date. All these factors have contributed to its growing popularity over the other forms of investments.

What are Preferred Shares – Debt or Equity? Video

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