Introduction
Preference share or preferred stock refers to the type of equity investment that gives shareholders priority over ordinary shareholders in payment of dividends and repayment of capital in case of liquidation. It combines the characteristics of both equity shares and debt instruments such as debentures and bonds. It gives more stable returns than equity shares.
Key Characteristics Of Preference Shares
* Generally companies set a fixed rate of dividend for preference shares
* Preference share holders cannot get voting right it means they don't have decision making power
* Preference shareholders are paid after creditors and before ordinary stockholders in case of liquidation
* These shares may be redeemable or irredeemable
* They are less riskier than ordinary shares
Understanding The Pros And Cons Of Preference Shares
Pros
The main benefits or advantages of preference shares can be highlighted as follows:
1. Regular Predictable Income
One of the main advantages of preference shares is stable income. Generally dividends are paid on fixed rate that provides stable income stream.
2. Priority Claim On Dividends And Assets
Preference shareholders get dividends before common stock holders because companies promise to pay fixed rate of dividends to the preference stock holders. There is less risk of capital loss because preference shareholders get paid before equity shareholders in case of liquidation.
3. Lower Risk
Preference share involves lower risk than equity share because of less volatility and higher claim on assets and dividends. So, it is considered as a safer investment option.
4. No Interference On Decision Making
Preference shareholders do not have voting rights so they cannot interfere in the decision making process of the company. So, there will be no management interference.
5. Flexibility
Preference shares are more flexible than common shares because they can be structured as per the investors needs, like redeemable or irredeemable, convertible or non-convertible and cumulative or non-cumulative.
Cons
The main drawbacks or disadvantages of preference share are as follows:
1. No Voting Rights
One of the major drawbacks of preference shares is that investors don't have voting rights that limits influence over management decisions.
2. Financial Burden
Because of fixed rate of dividends it may create financial burden for the company if company cannot perform well and profits are low.
3. Not Guaranteed Returns
Non-cumulative preference share holders may not get dividends if company faces financial pressure because of poor operations or other unfavorable situations.
4. Interest Rate Risk
If market interest rate rises then value of preference stock will fall.
5. Low Liquidity
It is difficult to sell preference shares as compared to equity shares because of lower trading volume. So, it is less liquid in stock market.
6. Limited Growth Potential
Preference shares have limited growth potential than common shares that limits the potential for capital gains.
