Preference capital represents a hybrid form of financing it partakes some characteristics of equity and some attributes of debentures. It resembles equity in the following ways:
(a) preference dividend is payable only out of distributable profit
(b) Preference dividend is not an obligatory payment. The payment of preference dividend is entirely within the discretion of directors
(c) preference dividend is not a tax-deductible payment
Preference capital is similar to debentures in several ways: (i) the dividend rate on preference capital is usually fixed, (ii) the claim of preference shareholders is prior to the claim of equity shareholders, and (iii) preference shareholders do not normally enjoy the right to vote.
Features of Preferences:
The features attached to preference shares may vary along the following dimensions: accumulation of dividends, callability, convertibility, redeemability, participation in surplus profits and assets, and voting power.
Accumulation of Dividends
Preference shares may be cumulative or non-cumulative with respect to dividends. Barring a few exceptions, preference shares in India carry cumulative feature with respect to dividends. The unpaid dividends on cumulative preferences shares are carried forward and payable when the dividend is resumed. For example, if the dividend payment on a 13 percent cumulative preferred share is skipped for 4 years, a divided arrear of 52 percent is payable. A company cannot declare equity dividends unless preference dividends are paid with arrears.
The terms of preference share issue may contain a call feature by which the issuing company enjoys the right to call the preference shares, wholly or partly, at a certain price.
Preference shares may sometimes be converted into equity shares. The holders of convertible preference shares enjoy the option of converting preference shares into equity shares at a certain ratio during a specified period. For example, the preference shareholders may enjoy the option of converting preference shares into equity shares in the ratio of 1:5 after 2 years for a period of 3 months.
Preference shares may be perpetual or redeemable. A perpetual preference share has no maturity period, whereas a redeemable preference share has a limited life after which it is supposed to be retired. Most preference issues are redeemable.
Preference shares do not carry voting rights. A preference shareholder, however is entitled to vote on every resolution placed before the company if (i) the preference dividend is in arrears for two years or more in the case of cumulative preference shares, or (ii) the preference dividend has not been paid for a period of two or more consecutive preceding years or for an aggregate period of three or more years in the preceding six years ending with the expiry of the immediately preceding financial year.
Cumulative Convertible Preference Shares
A new financial instrument labeled as â€˜Cumulative Convertible Preferenceâ€™ (CCP) share was introduced in 1985. This instrument is issued as preference share carrying a dividend rate of 10 percent. The preference shares are compulsorily convertible into equity shares between 3 years and 5 years from the date of issue.
The salient features of CCP shares are: (i) Only public limited companies are entitled to issue CCP shares (ii) The CCP shares must be listed on one or more recognized stock exchanges in the country. (iii) The funds raised fro CCP shares should be applied towards setting new projects, expansion or diversification of existing projects, normal capital expenditure for modernization, and working capital requirement.
The objective of introducing CCP shares was to offer the investor an assured minimum return together with the prospect of appreciation associated with equity.
This instrument has proved to be unpopular so far on account of certain limitations: (i) It does not provide any benefit under the Income Tax Act. (ii) It represents an expensive source of finance.