Preference Shares

What are Preference Shares?

Preference shares, also known as preferred stock, represent a class of ownership in a corporation with a higher claim on assets and earnings than common stock. Typically, preference shares offer fixed dividends paid out before any dividends are issued to common stockholders.

Key Characteristics of Preference Shares:

Dividend Preference: Preference shareholders receive dividends before common shareholders. These dividends are usually at a fixed rate.
Asset Distribution: In the event of a liquidation, preference shareholders have a higher claim on assets compared to common shareholders.
Convertible: Some preference shares can be converted into a specified number of common shares, giving the shareholder the potential for capital appreciation.
Callable: Companies may have the option to repurchase (or “call”) the preference shares at a predetermined price after a certain date.
Non-voting: Typically, preference shares do not come with voting rights unless specified otherwise in the terms of issuance.

Examples

Cumulative Preference Shares: These shares accumulate unpaid dividends. If a company skips dividend payments, the amount is carried forward to subsequent periods, and cumulative shareholders must be paid all dividends due before common shareholders receive any dividends.
Non-Cumulative Preference Shares: These shares do not accumulate unpaid dividends. If a company does not declare a dividend in a given year, non-cumulative shareholders do not receive any dividend for that year, and the omission does not carry forward.
Participating Preference Shares: In addition to the fixed dividends, these shares allow shareholders to receive additional dividends based on predetermined conditions or participate in extra earnings.

Frequently Asked Questions (FAQs)

Q1: Do preference shares have voting rights?

A1: Typically, preference shares do not carry voting rights. However, they may be granted voting rights under certain conditions as stipulated in their issuance terms.

Q2: Can preference shares be converted to common shares?

A2: Some preference shares are convertible, meaning they can be exchanged for a specified number of common shares under certain conditions or after a certain period.

Q3: What happens to preference shares in the event of liquidation?

A3: Preference shareholders have a higher claim on the company’s assets than common shareholders, meaning they are paid out from the remaining assets before common shareholders during liquidation.

Q4: How are dividends on preference shares taxed?

A4: Dividends received from preference shares are generally taxable to the shareholder, and the exact tax treatment can vary based on jurisdiction and specific tax laws.

Common Stock: Equity ownership that comes with voting rights and potential for variable dividends. Common stockholders are the last to be paid in the event of a bankruptcy.
Cumulative Dividend: A feature of some preference shares that ensures any missed dividend payments are accumulated and must be paid out before any dividends can be issued to common shareholders.
Convertible Securities: Financial instruments, such as bonds or preference shares, that can be converted into another form of security, typically common stock.
Callable Shares: Preference shares that a company can repurchase at a pre-set price after a certain date.

Online References to Online Resources

Suggested Books for Further Studies

“Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe - A comprehensive textbook covering all aspects of corporate finance, including preference shares.
“Investments” by Zvi Bodie, Alex Kane, Alan Marcus - This book provides an in-depth understanding of various investment securities, including preferred stocks.
“The Intelligent Investor” by Benjamin Graham - A classic investment book that includes sections on preferred stocks and their role in an investment portfolio.
“Security Analysis” by Benjamin Graham and David Dodd - Another classic, focused on in-depth security analysis, including preferred stocks.

Fundamentals of Preference Shares: Corporate Finance Basics Quiz

### Which of the following rights is typically NOT associated with preference shares? - [ ] Dividend preference - [ ] Priority in asset distribution - [x] Voting rights - [ ] Fixed dividend rate > **Explanation:** Preference shares generally do not have voting rights. They do, however, have dividend preference, priority in asset distribution, and a fixed dividend rate. ### What is a primary advantage for investors of holding preference shares over common stock? - [ ] Higher potential for capital appreciation - [x] Priority in dividend payments - [ ] Increased voting power - [ ] Lower taxation on dividends > **Explanation:** Preference shareholders have priority in receiving dividend payments before any are made to common stockholders, which is a primary advantage. ### What is the feature of cumulative preference shares with regards to unpaid dividends? - [ ] They do not accumulate unpaid dividends. - [x] Unpaid dividends accumulate and must be paid out before common share dividends. - [ ] They convert unpaid dividends into common shares. - [ ] Accumulated unpaid dividends are lost. > **Explanation:** Cumulative preference shares accumulate unpaid dividends, which must be paid out in full before any dividends can be issued to common shareholders. ### In the event of liquidation, who has a higher claim on assets, common shareholders or preference shareholders? - [ ] Common shareholders - [x] Preference shareholders - [ ] Both have equal claim - [ ] It depends on the company’s policy > **Explanation:** In the event of liquidation, preference shareholders have a higher claim on the company's assets than common shareholders. ### Which type of preference shares allows the holder to convert them into common shares? - [ ] Callable preference shares - [ ] Non-cumulative preference shares - [x] Convertible preference shares - [ ] Participating preference shares > **Explanation:** Convertible preference shares can be converted into a specified number of common shares under certain conditions. ### What type of preference shareholders can receive additional dividends based on company profits or conditions? - [x] Participating preference shares - [ ] Cumulative preference shares - [ ] Non-cumulative preference shares - [ ] Callable preference shares > **Explanation:** Participating preference shares allow holders to receive additional dividends over and above the fixed rate, based on the company's profits or certain preconditions. ### How are dividends typically treated for tax purposes for preference shareholders? - [ ] Dividends are tax-exempt. - [ ] Dividends always receive lower tax rates. - [x] Dividends are generally taxable. - [ ] Taxation varies only by company policy. > **Explanation:** Dividends received from preference shares are generally taxable to the shareholder, following specific tax regulations in their jurisdiction. ### Can preference shares be repurchased by the issuing company? - [x] Yes, if the shares are callable. - [ ] No, preference shares cannot be repurchased. - [ ] Yes, but only with shareholder approval. - [ ] Only in the event of company liquidation. > **Explanation:** Callable preference shares allow the issuing company to repurchase them at a fixed price after a certain date. ### Do non-cumulative preference shares carry forward unpaid dividends? - [ ] Yes, they carry forward unpaid dividends. - [x] No, they do not carry forward unpaid dividends. - [ ] They convert unpaid dividends into common shares. - [ ] They accrue interest on unpaid dividends. > **Explanation:** Non-cumulative preference shares do not carry forward unpaid dividends; if a dividend is missed, it does not accumulate for future payment. ### What determines whether preference shares are converted into common stock? - [ ] Company performance - [ ] Shareholder vote - [x] Terms specified in the share agreement - [ ] Annual company profits > **Explanation:** The ability and conditions under which preference shares can be converted into common stock are determined by the specific terms laid out in the share agreement at the time of issuance.

Thank you for exploring the key concepts of preference shares through our informative guide and challenging quiz. Keep up the good work on mastering corporate finance fundamentals!