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COMPUTER ORIENTED ACCOUNTING SYSTEM PREFERENCE CAPITAL (PREFERENCE SHARES)
PREFERENCE CAPITAL (PREFERENCE SHARES)
1. Introduction and Meaning
Preference capital refers to the capital raised by a company through the issue of preference shares. Preference shares are a special class of shares that carry certain preferential rights over equity shares. These shareholders receive a fixed rate of dividend before any dividend is paid to equity shareholders, and they also have a preferential right to repayment of capital in the event of liquidation of the company.
Preference shares are often called hybrid instruments because they combine features of both equity (ownership and no fixed maturity) and debt (fixed rate of return and priority in payment).
Hybrid Nature of Preference Shares
- Fixed Dividend: Similar to debt, preference shares carry a fixed rate of dividend.
- Priority in Payment: Dividends must be paid to preference shareholders before any dividend is paid to equity shareholders.
- Repayment of Capital: At the time of liquidation, preference shareholders have a prior claim on assets over equity shareholders after outside debts are cleared.
[!NOTE]
Simple meaning: Preference shareholders are like "special owners" who get their dividend first and their capital back before equity shareholders, but in return, they usually do not get voting rights.
2. Features of Preference Capital
| Feature | Explanation |
|---|---|
| Fixed dividend rate | The dividend is paid at a predetermined percentage (e.g., 10% preference shares means ₹10 per ₹100 face value). |
| Preferential dividend right | Dividend on preference shares must be paid before any dividend on equity shares. |
| Preferential repayment right | In case of liquidation, preference share capital is repaid before equity share capital (but after all debts and liabilities). |
| No voting rights | Generally, preference shareholders do not have voting rights in company decisions. However, they may get voting rights if dividend is not paid for a specified period. |
| Cumulative or non-cumulative | If dividends are not paid in a year, they may accumulate (cumulative) or be lost (non-cumulative). |
| Redeemable or perpetual | Most preference shares are redeemable (repaid after a fixed period). Some are perpetual (no fixed repayment). |
| No tax benefit | Unlike interest on debt, dividend on preference shares is not tax-deductible for the company. |
3. Types of Preference Shares
Preference shares can be classified based on different characteristics:
Common Types of Preference Shares
A. Based on Dividend Accumulation
- Cumulative Preference Shares: Unpaid dividends accumulate and are carried forward to future years as arrears.
- Non-Cumulative Preference Shares: Dividends do not accumulate. If the company skips a dividend in a year, it is lost forever.
| Type | Description |
|---|---|
| Cumulative preference shares | If dividend is not paid in any year, it accumulates and must be paid in future years before any dividend is paid to equity shareholders. |
| Non-cumulative preference shares | If dividend is not declared in a year, the right to that year’s dividend is lost forever. |
B. Based on Participation in Surplus
| Type | Description |
|---|---|
| Participating preference shares | In addition to fixed dividend, these shareholders have a right to share in the remaining profits (after equity dividend) or surplus on liquidation. |
| Non-participating preference shares | Shareholders get only the fixed dividend and no extra share in profits. (Most preference shares are non-participating.) |
C. Based on Convertibility
| Type | Description |
|---|---|
| Convertible preference shares | Can be converted into equity shares after a specified period or on certain conditions. |
| Non-convertible preference shares | Cannot be converted into equity shares; remain as preference shares until redemption. |
D. Based on Redemption
| Type | Description |
|---|---|
| Redeemable preference shares | Repaid by the company after a fixed period (maximum 20 years as per Companies Act, 2013). |
| Irredeemable (perpetual) preference shares | No fixed repayment date; treated as permanent capital. (Not allowed in India after Companies Act, 2013, except for certain financial institutions.) |
4. Advantages of Preference Capital (From Company’s Perspective)
| Advantage | Explanation |
|---|---|
| No dilution of control | Preference shareholders generally have no voting rights, so existing owners retain full control. |
| Fixed cost | The dividend rate is fixed, allowing the company to plan its finances. |
| No obligation to pay if no profit | Unlike interest on debt, dividend on preference shares is not mandatory. If there are no profits, the company can skip dividend (except for cumulative arrears). |
| Trading on equity | Preference capital can be used to increase returns to equity shareholders (like financial leverage, but with less risk than debt). |
| Flexible terms | The company can design preference shares with varying features (redeemable, convertible, etc.). |
| Attracts conservative investors | Investors who want fixed returns but are unwilling to take debt risk prefer preference shares. |
5. Disadvantages of Preference Capital
| Disadvantage | Explanation |
|---|---|
| Higher cost than debt | Dividend on preference shares is not tax-deductible, whereas interest on debt is. Therefore, effective cost is higher. |
| Fixed dividend burden | Even though not legally binding like interest, skipping dividend damages reputation and may affect future fundraising. |
| Cumulative arrears | If dividends are skipped on cumulative preference shares, the accumulated amount becomes a future liability. |
| Limited marketability | Preference shares are less actively traded than equity shares, making them less liquid. |
| No tax shield | Unlike debt, no tax benefit on dividend paid. |
| Redemption obligation | Redeemable preference shares require repayment of capital after a period, creating cash outflow pressure. |
6. Preference Capital vs Equity Shares vs Debt
| Basis | Preference Shares | Equity Shares | Debt (Debentures/Loans) |
|---|---|---|---|
| Return | Fixed dividend | Variable dividend | Fixed interest |
| Payment priority | After debt, before equity | Last | First |
| Repayment | Redeemable after period | Permanent | Fixed maturity |
| Tax deduction | No | No | Yes (interest tax shield) |
| Voting rights | Usually no | Yes | No |
| Cost | Moderate (between debt and equity) | Highest | Lowest |
| Risk for investor | Moderate | High | Low |
| Risk for company | Moderate (no legal compulsion to pay dividend, but arrears matter) | Low (dividend optional) | High (interest mandatory) |
7. Cost of Preference Capital ($K_p$)
The cost of preference capital is the dividend expectation of preferred shareholders. Unlike interest on debt, preference dividends are paid out of after-tax profits, meaning they do not provide any tax shield.
1. Cost of Irredeemable Preference Shares
$K_p = \frac{\text{Dividend per share}}{\text{Net proceeds per share}}$
Where:
- Dividend per share = Face value $\times$ Dividend rate
- Net proceeds = Issue price - Flotation costs (underwriting, brokerage, etc.)
Example:
- Face value = ₹100
- Dividend rate = 10%
- Issue price = ₹100
- Flotation cost = ₹5 per share
- Dividend = $100 \times 10% = ₹10$
- Net proceeds = $100 - 5 = ₹95$
- $K_p = \frac{10}{95} = 10.53%$
Formula for Redeemable Preference Shares
When preference shares are to be redeemed after a certain period, the cost is calculated using the internal rate of return (IRR) approach:
$K_p = \frac{\text{Dividend} + \frac{\text{Redemption value} - \text{Net proceeds}}{n}}{\frac{\text{Redemption value} + \text{Net proceeds}}{2}}$
Where:
- n = number of years to redemption.
Example:
- Face value = ₹100
- Dividend = 10% = ₹10
- Issue price = ₹100 (net proceeds)
- Redemption after 5 years at par (₹100)
- No flotation cost
- $K_p = \frac{10 + \frac{100 - 100}{5}}{\frac{100 + 100}{2}} = \frac{10}{100} = 10%$
If redeemed at a premium of 5% (₹105):
- $K_p = \frac{10 + \frac{105 - 100}{5}}{\frac{105 + 100}{2}} = \frac{10 + 1}{\frac{205}{2}} = \frac{11}{102.5} = 10.73%$
8. Irredeemable vs Redeemable Preference Shares
| Basis | Irredeemable | Redeemable |
|---|---|---|
| Repayment | No fixed date | Repaid after fixed period (max 20 years) |
| Cost calculation | Simple formula (dividend / net proceeds) | IRR-based formula |
| Legal status | Restricted in India (not allowed for most companies) | Permitted |
| Flexibility | Less flexible for company | More flexible |
9. Cumulative vs Non-Cumulative Preference Shares – Example
Cumulative Preference Shares:
- Dividend rate = 10% on ₹1,00,000 (₹10,000 per year)
- Year 1: No profit $\rightarrow$ No dividend (arrears = ₹10,000)
- Year 2: Profit ₹25,000 $\rightarrow$ Pay arrears ₹10,000 + current year ₹10,000 = ₹20,000
- Year 3: Profit ₹5,000 $\rightarrow$ Pay remaining? Actually no, only ₹5,000 can be paid, balance arrears continue.
Non-Cumulative Preference Shares:
- Year 1: No profit $\rightarrow$ No dividend (arrears not carried forward)
- Year 2: Profit ₹25,000 $\rightarrow$ Pay only current year dividend ₹10,000 (previous year lost)
10. Participating vs Non-Participating – Example
- Non-participating: Gets only fixed dividend (e.g., ₹10 per share).
- Participating: After paying fixed dividend to preference and a certain dividend to equity, any remaining surplus is shared proportionately.
Example:
- Preference capital ₹1,00,000 (10% = ₹10,000)
- Equity capital ₹2,00,000
- Profit after tax = ₹50,000
- Preference dividend = ₹10,000
- Equity dividend (say 10% on face value) = ₹20,000
- Remaining surplus = ₹20,000
- Participating preference may get a share of this surplus (e.g., in proportion to capital).
11. Accounting Treatment of Preference Share Capital
In the balance sheet, preference share capital is shown under Shareholders’ Funds (equity and liabilities side).
Journal Entry for Issue of Preference Shares:
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Bank A/c ... Dr. | xxx | ||
| To Preference Share Capital A/c | xxx | ||
| To Securities Premium A/c (if any) | xxx | ||
| (Being preference shares issued) |
Dividend Payment Entry:
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Preference Dividend A/c ... Dr. | xxx | ||
| To Bank A/c | xxx | ||
| (Being dividend paid) |
Transfer to P&L (Dividend is an appropriation of profit, not an expense):
| Date | Particulars | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Profit & Loss Appropriation A/c ... Dr. | xxx | ||
| To Preference Dividend A/c | xxx |
12. Illustrative Problems
Problem 1: Cost of Irredeemable Preference Shares
Question: A company issues 10,000, 12% preference shares of ₹100 each. Issue expenses are ₹2 per share. Calculate cost of preference capital.
Solution:
- Face value = ₹100
- Dividend = $100 \times 12% = ₹12$
- Net proceeds = $100 - 2 = ₹98$
- $K_p = \frac{12}{98} = 12.24%$
Problem 2: Cost of Redeemable Preference Shares
Question: A company issues 8% preference shares of ₹100 each at a discount of 5%. They are redeemable after 6 years at par. Flotation cost ₹3 per share. Calculate cost.
Solution:
- Face value = ₹100
- Dividend = ₹8
- Issue price = $100 - 5% \text{ discount} = ₹95$
- Flotation cost = ₹3
- Net proceeds = $95 - 3 = ₹92$
- Redemption value = ₹100
- $n = 6$ years
- Average annual dividend with redemption adjustment = $[8 + \frac{100 - 92}{6}] = 8 + \frac{8}{6} = 8 + 1.333 = ₹9.333$
- Average investment = $\frac{100 + 92}{2} = ₹96$
- $K_p = \frac{9.333}{96} = 9.72%$
Problem 3: Cumulative Preference Dividend Arrears
Question: A company has 5,000, 10% cumulative preference shares of ₹100 each. The company did not pay dividend in year 1 and year 2. In year 3, it has distributable profit of ₹2,00,000. How much will preference shareholders receive?
Solution:
- Annual preference dividend = $5,000 \times 100 \times 10% = ₹50,000$
- Arrears for 2 years = $50,000 \times 2 = ₹1,00,000$
- Current year dividend = ₹50,000
- Total due = ₹1,50,000
- Profit available = ₹2,00,000 $\rightarrow$ Preference shareholders receive full ₹1,50,000. Balance ₹50,000 goes to equity.
Problem 4: WACC Including Preference Capital
Question: A company has:
- Equity: ₹20,00,000 (cost 15%)
- Preference: ₹5,00,000 (cost 10%)
- Debt: ₹10,00,000 (cost 8% after tax)
Calculate WACC.
Solution:
- Total capital = 20 + 5 + 10 = ₹35,00,000
| Source | Amount | Weight | Cost | Weighted Cost |
|---|---|---|---|---|
| Equity | 20,00,000 | 20/35 = 0.5714 | 15% | 8.57% |
| Preference | 5,00,000 | 5/35 = 0.1429 | 10% | 1.43% |
| Debt | 10,00,000 | 10/35 = 0.2857 | 8% | 2.29% |
| WACC | 12.29% |
13. Practice Problems
Problem 1
A company issues 8,000, 9% preference shares of ₹50 each at a premium of ₹5 per share. Issue expenses are ₹2 per share. Calculate cost of preference capital (irredeemable).
Problem 2
10% redeemable preference shares of ₹100 each are issued at ₹95. They are redeemable after 5 years at ₹105. Flotation cost ₹4 per share. Find $K_p$.
Problem 3
A company has 2,000, 12% cumulative preference shares of ₹100 each. No dividend paid in year 1 and year 2. In year 3, profit available for distribution is ₹60,000. How much will preference shareholders get? How much for equity?
Problem 4
Calculate WACC: Equity ₹30,00,000 (cost 16%), Preference ₹10,00,000 (cost 11%), Debt ₹20,00,000 (cost 7% after tax).
14. Summary – Key Points
- Preference capital is a hybrid source – fixed dividend like debt, but ownership like equity.
- Features: Fixed dividend, preferential payment, usually no voting rights, redeemable or perpetual.
- Types: Cumulative/non-cumulative, participating/non-participating, convertible/non-convertible, redeemable/irredeemable.
- Advantages: No dilution of control, no mandatory dividend (but arrears), fixed cost.
- Disadvantages: Higher cost than debt (no tax shield), cumulative arrears burden, limited marketability.
- Cost of preference capital is calculated using dividend/net proceeds for irredeemable, and IRR formula for redeemable.
- Preference shares are shown under Shareholders’ Funds in the balance sheet.
Interactive Practice Lab
Test your mastery of Preference Capital with our MCQ-based assessment.