Less Preferred Preference Shares, LD Mahat

Background

Despite being useful capital market instrument, preference shares are less preferred by companies.

Preference share is a special class of share which pays a fixed dividend as a percentage of the par value of shares. It is a hybrid type of security. It is an ownership security like an equity share, but carries a fixed rate of dividend like a debenture. Preference share holders can claim over company’s income after the company meets claims of creditors. However, the claim shall be before ordinary shareholders receive any income. Like debt instruments, preference shares do not provide controlling interest in the company. Like equity shares, dividend payments to preference shareholders are not deductible for tax purposes.

Less Preferred in Nepalese Market

Preference shares are less preferred in Nepalese capital market. Although preference shares are one of the most opted routes of mobilising funds in the corporate world, we have not seen issue of preference shares by Nepalese companies since a long period.

Financing Options

When a company needs funds to finance its project it may have two options: raising debt funds or the issue of equity. If a company funds the project by way of debt, it may have to borrow from banks or issue debt instruments. The debt fund not only increases the bankruptcy risk, the company also has to undergo constant scrutiny or monitoring of the banks.

On the other hand, if the company manages required fund by the issue of equity shares, it will result in lower earnings per share (EPS). A lower EPS may bring down the price of shares in the market. The promoters of the company may also lose the controlling interest in the company if the outsiders subscribe the shares. Issue of preference shares in such a situation might reconcile these contradictory elements.

Preference Shares:  Pros and Cons

Preference share offers various benefits to the companies. Issue of preference shares does not dilute the EPS, as it is not considered for the purpose of computing EPS. At the same time, it is included in the component of equity while calculating the debt/equity ratio of the company. Moreover, issue of preference shares does not dilute the controlling interest in the company. This is because the events affecting their claims on dividend triggers the rights of the preference shareholders. These advantages have made preference shares more attractive than ordinary shares.

Preference shares are generally regarded as slightly lower risk than ordinary shares. This is because if a company goes bust, preference shareholders are ahead of ordinary shareholders in the queue for payoffs. It may be rare for a big company to collapse, but it is possible that a troubled firm may not be able to pay a dividend to all shareholders. Again, preference shareholders benefit because the company needs to pay them first.

Cumulative Preference Shares

Generally, preference shares are cumulative in nature. A company may not be able declare the dividend on preference shares in a particular year because of bad performance. In such a case, the company needs to accumulate the dividend and must pay the full accumulation before it pays any dividends to the ordinary shareholders. Other financial restrictions on management also typically come into play when the preference dividends are in arrears. Preference shareholders do not participate financial good fortune of the company resulting an increase in its earnings.

Tax Implications

While disallowance of preference dividend for computing taxable income causes disadvantages to the company issuing preference shares, a lower rate of tax on dividend may attract the investors. For example, a company may deduct income tax on interest income as well as dividend at five percent. Given the same coupon rate, income after tax of preference shareholders becomes higher than the holders of debt instruments and the preference share becomes attractive to the investors.

The fixed rate of return offered on preference shares can appear attractive to the investors when the performance of the company is hit. But preference shareholders lose out if a company does well because they will continue to be paid their fixed rate of dividend, rather than increased dividends. The preference shareholders get priority in the payment of dividend over the ordinary shareholders.

Conclusion

A preference share, being a hybrid financial instrument, combines the benefit of equity shares and debt instrument. Since preference shares are not considered as a part of equity for the purpose of computing EPS, it will not affect this ratio. A company can raise funds from preference shares without a fear of equity dilution. On the other hand, preference shares are considered as a part of equity at the time of computing debt/equity ratio. An increased equity component in the capital structure of a company may help in bargaining for better rate of interest. Also, the company may get better terms of debt financing in the market. Nepalese companies may capitalize the benefits of preference shares in the days to come.

1 Comment »

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.