Preference shares: Sec. 85(1) of the Companies Act defines preference shares as those shares which carry preferential rights as the payment of dividend at a fixed rate and as to repayment of capital in case of winding up of the company. Thus, both the preferential rights viz.
(a) Preference in payment of dividend and
(b) Preference in repayment of capital in case of winding up of the company, must attach to preference shares.
The rate of dividend on these shares is fixed and the dividend on these shares must be paid before any dividend is paid to ordinary shares. Directors, however, may decide not to pay any dividend to any class of shareholders even if there are sufficient profits. But, if any how, they decide to pay the dividend, preference shareholders will get the priority to pay the ordinary shareholders.
Following are the basic features of preference share:
a) Fixed rate of dividend
b) Preferential payment of dividend
c) Preferential right in redemption of capital in case of winding up of a company.
d) Absence of voting rights
Cumulative preference shares enjoy the right to receive the dividend in arrears for the years in which company earned no profits or insufficient profits, in the year in which company earns profits.
In case of non-cumulative preference shares dividend does not accumulate and therefore, no arrears of dividend will be paid in the year of profits. If company does not have any profits in a year, no dividend will be paid to non-cumulative preference shareholders.
Redeemable Preference shares are preference shares which have to be repaid by the company after the term of which for which the preference shares have been issued.
Irredeemable Preference shares means preference shares need not repaid by the company except on winding up of the company. However, under the Indian Companies Act, a company cannot issue irredeemable preference shares. In fact, a company limited by shares cannot issue preference shares which are redeemable after more than 10 years from the date of issue. In other words the maximum tenure of preference shares is 10 years. If a company is unable to redeem any preference shares within the specified period, it may, with consent of the Company Law Board, issue further redeemable preference shares equal to redeem the old preference shares including dividend thereon.
A company can issue the preference shares which from the very beginning are redeemable on a fixed date or after certain period of time not exceeding 10 years provided it comprises of following conditions:-
a) It must be authorised by the articles of association to make such an issue.
b) The shares will be only redeemable if they are fully paid up.
c) The shares may be redeemed out of profits of the company which otherwise would be available for dividends or out of proceeds of new issue of shares made for the purpose of redeem shares.
d) If there is premium payable on redemption it must have provided out of profits or out of shares premium account before the shares are redeemed.
When shares are redeemed out of profits a sum equal to nominal amount of shares redeemed is to be transferred out of profits to the capital redemption reserve account. This amount should then be utilised for the purpose of redemption of redeemable preference shares. This reserve can be used to issue of fully paid bonus shares to the members of the company.
Where the preference shareholders are given a right to covert their holding into ordinary shares, within a specified period of time, such shares as known as convertible preference shares.
The holders of non-convertible preference shares have no such right of conversion.
The holders of participating preference shares have a right to participate in the surplus profits of the company remained after paying dividend to the ordinary shareholders and preference shareholders at a fixed rate.
The preference shares which do not have such right to participate in surplus profits, are known as non-participating preference shares.
Advantages of Preference shares
1. Helpful in raising long term capital for a company.
2. There is no need to mortgage property on these shares.
3. Redeemable preference shares have the added advantages of repayment of capital whenever there is surplus in the company.
4. Rate of return is guaranteed.
Disadvantages of Preference shares
1. Permanent burden on the company to pay a fixed rate of dividend before paying anything on the other shares.
2. Not advantageous to investors from the point of view of control and management as preferences shares do not carry voting rights.
3. Compared to other fixed interest bearing securities such as debentures, usually the cost of raising the preference share capital is higher.
Conditions for redemption of Preference Shares:
Under section 80 of the Companies Act, 1956, a company should have to follow the conditions:
1. There must be a provision in the Articles of Association regarding the redemption of preference shares.
2. The redeemable preference shares must be fully paid up. If there is any partly paid share, it should be converted in to fully paid shares before redemption.
3. The redeemable preference shareholders should be paid out of undistributed profit/ distributable profit or out of fresh issue of shares for the purpose of redemption.
4. If the shares are redeemed at a premium, it should be should be provided out of securities premium or profit and loss account or general reserve account.
5. The proceeds from fresh issue of debentures cannot be utilized for redemption.
6. The amount of capital reserve cannot be used for redemption of preference shares.
7. If the shares are redeemed out of undistributed profit , the nominal value of share capital, so redeemed should be transferred to Capital Redemption Reserve Account. This is also known as capitalization profit.