Learning Objectives Sensitize to the basic features of preferred stock. Assess potentiality of preferred stock as a source of financing. Expose to the concept of preferred ordinaries and their utility in raising funds.
A. An Overview In addition to common stock, companies can raise long term funds by issue of preferred stock. This stock has preferential rights over other share holders as far as share in earnings and assets are concerned. The preferential rights are spelled out in the articles of association of the company to avoid any ambiguity.
B. Features of Preferred Stock B.1. Maturity Like common stock, preferred stock is not to be repaid, until closure of the company. However, to induce investors, redeemable preference shares are issued with a fixed period of maturity. These shares can be issued with premium on maturity.
B. Features of Preferred Stock Companies, further, can issue convertible preference shares. These are converted into common stock after the stipulated period. This clause is offered to attract more investors who earn fixed income initially.
B.Features of Preferred Stock B.2. Claims on income - Unlike common stock, preferred stock is entitled to preferential dividend at a fixed rate specified at the time of issue. There is no legal obligation on companies to declare dividends. Declaration of dividends is a prerogative of the Board of Directors. But once dividends are declared, preference shareholders must be paid first before common stock holders.
B. Features of Preferred Stock B.2. Claims on income - contd. In case of Cumulative preference shares, if dividends are not paid in any year, unpaid dividends are carried forward for payment in subsequent years.
B. Features of Preferred Stock B.3. Claims on assets - No specific assets are pledged against preference shares. However, on closure of company, preference share holders have first right on assets of the company. The amount repayable to them is limited to the face value of the preference shares.
B. Features of Preferred Stock B.4. Controlling Power - No specific voting rights in management of election of directors are available to preference share holders. However, on resolutions that directly affect their rights including winding up of the company, reduction in the share capital, preference share holders have the right to vote. Similarly, if dividends are not paid on the shares, they can vote on all resolutions.
B. Features of Preferred Stock Review of these features indicates, that preference share is a hybrid corporate security that is partly a debt and has some rights associated with common stock. Even though they treated as debt, failure to pay dividends on preference shares does not result in the bankruptcy of the company.
C. Potentiality of Preferred Stock as a Source of Finance. Preference shares allow the company to obtain funds from those investors who are cautious and averse to risks. They bring in permanent capital without mortgage on any assets. Dividend payable on these shares is fixed, but not mandatory. In case management wants to plough back all its earnings into business, it is not forced to pay dividends against preference shares.
C. Potentiality of Preferred Stock as a Source of Finance. By introducing call or redemption option in preference shares, finance manager can introduce flexibility in finance structure of the company. As these shares do not carry voting rights, management succeeds in retaining control with itself. When share markets are inactive, and uncertainty prevails in economy, companies can attract investors by offering this instrument which offers both certain returns and safety.
D. Growing Popularity of Preference Shares in India Preference Shares, especially those redeemable in and around 18 months are very popular with Indian companies hungry for short term funding. This source of finance increases net worth of the company thereby expanding its borrowing capacity.
D. Growing Popularity of Preference Shares in India The instrument is guaranteed for dividends and repayment by a merchant banker by astute finance managers to reduce risks and make it further attractive to investors. It must be noted that, this source proves costly against long term debt as, while interest on debt is tax deductible, dividends are distributed from post tax earnings.
D. Growing Popularity of Preference Shares in India Further, to be able to declare agreed dividends, company must consistently make profits at a rate higher than the dividend rate. In the eventuality of failure to pay dividends on time, it may become necessary to share control with preference share holders.
D. Growing Popularity of Preference Shares in India Finance managers must know that investors go for preference shares for : Steady returns. Prior claims on earnings and assets. Dividends at fixed rates, even if markets fall. Voting power if their rights are affected.
D. Growing Popularity of Preference Shares in India Finance managers must know that investors for preference shares stand to lose as : Their share in earnings & assets is limited. There is no legal compulsion for management to declare dividends.
E. Decision Making on Issue of Preference Stock Finance manager can elect for preferred stock when Levels of sales and income are unstable but average earning rate is higher than what is to be promised on preferred stock. Adequate fixed assets are not available to raise long term debt. Prevailing interest rates make issue of preferred stock economical vis-à-vis common stock.
F. Management of Preference Stock If market conditions prevailing at the time of issue of preferred stock change, and finance manager finds long term debt can be raised economically; a decision is required on repayment of preferred stock. Refunding problem arises particularly in the case of non-callable preferred stock or of an issue with a very high call premium.
G. Preferred Ordinary Shares PREFERRED STOCK FINANCING G1 Nature of Preferred Ordinary Shares Redeemable within a specified time frame. Holders have option to convert the shares into common stock on maturity. Cumulative annual, or variable dividend. Carry voting rights. More risky than preferred stock; but less so than the ordinary shares. In the year 2000, Indian Companies were allowed to issue shares with non-voting or differential voting rights.
G. Preferred Ordinary Shares G2 Significance of Preferred Equity It permits a green field project to raise funds offering variable returns even before the script is listed on the bourse through an initial public offer. Through conversion option initial investors can be retained as ordinary shareholders. Next chapter Eight, Debenture Financing.