Preference Shares

Also known as Preference Stock

Companies issue preference shares in order to strengthen their balance sheet.
Companies often need to strengthen their balance sheets for any of the reasons below:
Avoid violating the covenants of their loan agreement
Meet legally mandated debt to equity ratios (this applies to regulated industries such as banking or insurance)
Provide the capital necessary to support expansion plans

Preference shares normally pay a higher dividend than normal shares as the investor will not benefit from the company's growth.
The main reason for a company issuing preference shares is that it will not dilute the ownership interest of the normal shares.
These have different characteristics than normal shares. Preference shares can have embedded options.

Preference Shares (US call this preferred Stock)
Usually pay dividend as a fixed percentage rate. If there is any shortage of money, their dividends must be paid out before other dividends. In the event of liquadation, preference shareholders have priority over ordinary shareholders. They have no voting rights. If the dividend cannot be paid then it is legally owed to them.

Preference Shares / Preferred Stock

2 classes of share capital - ordinary shares / preference shares

Preference shares usually pay a fixed dividend and are therefore more like a bond that an ordinary share.
But the dividend has to be paid out of profits which have "borne" tax, whereas interest on a loan stock is allowable against tax.

Against this disadvantage, the preference shares will not normally be counted in the "gearing" of a company whereas loan stocks will. And they are safer in that the company risks being closed down if it cannot pay interest on its loans where it could miss dividends on the preference shares without the same risk.

Preference shares are part of shareholder's funds but not part of ordinary shareholders funds.
They are share capital but not equity share capital.
They do not share in the rising prosperity of a company because their dividend is fixed and does not increase with rising profits.

But they are entitled to their dividend before the ordinary shareholders get anything, so the dividend is safer than that of ordinary shareholders.

If the company is wound-up/closed down preference shareholders are normally entitled to be repaid the par value of their shares before teh ordinary shareholders get anything.

Preferred Stock Differences

Dividend payments usually set at a fixed percentage of par/face value
Alternatively you could have a variable rae linked to a bechmark interest rate
Very unusual to have voting rights but does depend on the company

Difference Types of Preferred Stock

There are several different types of preferred stock that can be issued.
Think of these are normal common stock but with an embedded "call" option attached to them.
For each different type of preferred stock a slightly different type of option is attached
Redeemable - (very common)
Cumulative - (common)
Convertible -
Participating -

Redeemabe Option

callable
the company has the right to purchase the shares
May be called at par value or at a premium.

Cumulative Option

Means the dividends accrue even though they are not actually paid.
If the company is short of cash, the payment might be suspended
When it improves the payment is resumed and the accrued dividend is paid

Convertible Option

callable
Have an option to convert their shares into common stock using a pre-determined formula
(or it is automatically converted into common stock on a specific date)

Participating Option

entitled to take part in a further share of the profits through the payment of a participating dividend.
This dividend is typically less than the regular dividend paid to common stock shareholders

Exchangeable Option

Voting Rights Option

Preferred stock is the most expensive type of debt security that can be issued.
This is because dividend payments on preferred stock must be made from after-tax earnings.
However it has no maturity date and most of it is callable.

The Interest Sensitivity of a preference share is:
Interest Rate Sensitivity = (1 + Yield) / Yield