A:

Preference shares carry a number of benefits for both companies and investors. The chief benefit for shareholders is that preference shares have a fixed dividend  that must be paid before any dividends can be paid to common shareholders. While dividends are only paid if the company turns a profit, some types of preference shares (called cumulative shares) allow for the accumulation of unpaid dividends. Once the business is back in the black, all unpaid dividends must be remitted to preferred shareholders before any dividends can be paid to common shareholders.

In addition, in the event of bankruptcy and liquidation, preferred shareholders have a higher claim on company assets than common shareholders. This makes preference shares, also called preferred shares, particularly enticing to investors with low risk tolerance. The company guarantees a dividend each year, but if it fails to turn a profit and must shut down, preference shareholders are compensated for their investments sooner.

Other types of preference shares carry additional benefits. Convertible shares allow the shareholder to trade in preference shares for a fixed number of common shares. This can be a lucrative option if the value of common shares begins to climb. Participating shares offer the shareholder the opportunity to enjoy additional dividends above the fixed rate if the company meets certain predetermined profit targets. The variety of preference shares available and their attendant benefits means that this type of investment can be a relatively low-risk way to generate long-term income.

From the investor's perspective, the main disadvantage of preference shares is that preferred shareholders do not have the same ownership rights in the company as common shareholders. The lack of voting rights means the company is not beholden to preferred shareholders the way it is to equity shareholders, but the guaranteed return on investment largely makes up for this shortcoming. However, if interest rates rise, the fixed dividend that seemed so lucrative can quickly look like less of a bargain as other fixed-income securities emerge with higher rates.

Preference shares also have a number advantages for the issuing company. The lack of shareholder voting rights that may seem like a drawback to investors is beneficial to the business because it means ownership is not diluted by selling preference shares the way it is when ordinary shares are issued. The lower risk to investors also means the cost of raising capital for issuing preference shares is lower than that of issuing common shares. Issuing preference shares carries many of the benefits of both debt and equity capital and is considered to be a hybrid security.

Companies can also issue callable preference shares, which afford them the right to repurchase shares at their discretion. This means that if callable shares are issued with a 6% dividend but interest rates fall to 4%, the company can purchase any outstanding shares at the market price and then reissue shares with a lower dividend rate, thereby reducing the cost of capital. Shareholders, however, would consider this a disadvantage.

The chief disadvantage to companies is the higher cost of this type of equity capital relative to debt. However, financing through shareholder equity, either common or preferred, lowers a company's debt-to-equity ratio, which is considered by both investors and lenders to be a sign of a well-managed business.

RELATED FAQS
  1. What is the difference between preference and ordinary shares?

    Preferred shareholders have a higher priority claim to the assets of a corporation in case of insolvency than common shareholders. Read Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Learn about some reasons corporations might issue preference shares and why investors might value them more than common shares. Read Answer >>
  3. How does preferred stock differ from company issued bonds?

    Discover the primary differences between preferred stock and corporate bonds, two income-generating investment vehicles issued ... Read Answer >>
Related Articles
  1. Investing

    What are Preference Shares?

    Preference shares, also referred to as preferred shares, are equity shares that give the shareholders certain rights ahead of common shareholders. For instance, when the corporation declares ...
  2. Managing Wealth

    The Advantages of Preferred Dividends

    Preferred dividends are cash distributions a company pays on its preferred shares.
  3. Investing

    A Primer On Preferred Stocks

    Offering both income and relative security, these uncommon shares may work for you.
  4. Investing

    Valuation Of A Preferred Stock

    Determining the value of a preferred stock is important for your portfolio. Learn how it's done.
  5. Investing

    Prefer Dividends? Why Not Look At Preferred Stock?

    Preferred stock is an under-used option for income-seeking investors.
  6. Managing Wealth

    What is Convertible Preferred Stock?

    Convertible preferred stock is preferred stock that can be converted into common stock as of a predetermined date at a specified ratio.
  7. Investing

    Looking for Yield? Check Out This Preferred Stock ETF (PFF)

    Take a look at a review of the performance of the most popular preferred stock ETF, the iShares U.S. Preferred Stock ETF from BlackRock.
  8. Investing

    Investing in Preferred Stock:The Basics

    Preferred stocks provide income as well as the potential to appreciate in value.
RELATED TERMS
  1. Preferred Dividend

    A dividend that is accrued and paid on a company's preferred ...
  2. Current Dividend Preference

    A safety feature of preferred shares, whereby holders of such ...
  3. Noncumulative

    A type of preferred stock that does not pay the holder any unpaid ...
  4. Adjustable-Rate Preferred Stock - ARPS

    A type of preferred stock where the dividends issued will vary ...
  5. Accumulated Dividend

    A dividend on a share of cumulative preferred stock that has ...
  6. Cumulative Dividend

    A sum that publicly traded companies must remit to preferred ...
Hot Definitions
  1. Short Covering

    Short covering is buying back borrowed securities in order to close an open short position.
  2. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  3. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  4. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  5. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  6. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
Trading Center