Introduction

Preferred stock (also called preferred shares, preference shares or simply preferreds) is a stock which may have any combination of features not possessed by common stock including properties of both equity and a debt instrument, and is generally considered a hybrid instrument. Preferred are senior (i.e. higher ranking) to common stock, but subordinate to bonds in terms of claim (or rights to their share of the assets of the company)[1] and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the articles of association. Similar to bonds, preferred stocks are rated by the major credit-rating companies. The rating for preferred is generally lower, since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.

Definition of 'Preference Shares'

Company stock with dividends that are paid to shareholders before common stock dividends are paid out. In the event of a company bankruptcy, preferred stock shareholders have a right to be paid company assets first. Preference shares typically pay a fixed dividend, whereas common stocks do not. And unlike common shareholders, preference share shareholders usually do not have voting rights.

Types of Preference Shares

In general, there are four different types of preference shares (preferred stocks):
1) Cumulative and

Non cumulative shares:Cumulative preference shares give the right to the preference shareholders to claim the dividends that are not paid in the previous year and they are paid in preference to ordinary dividends. For non-cumulative or simple preference shares, any dividends that are unpaid or accrued in the previous year cannot be carried forward to the subsequent year or years in respect of that year, and that is considered lost by the shareholders. 2) Redeemable and Non-redeemable:A redeemable preference share is issued on the terms where they are liable to be redeemed at either a fixed time, or the company's option or at the shareholders option. In other words, the company can buy back preference shares at an agreed time and price. Non-redeemable or Irredeemable preference shares need not be repaid by the company except on winding up of the company. The company is not offering to buy back the securities.

3) Convertible and Non-convertible shares:Convertible Preference Shares are corporate fixed-income securities that the shareholders have the option of converting them into a certain number of ordinary shares after a predetermined time span or on a specific date. Non-Convertible Preference Shares are those which do not have the option of their conversion into the equity shares. 4) Participating and Non-participating:Participating Preference Shares are entitled to a fixed preferential dividend and have the right to participate further in the surplus profits after payment of certain rate of dividend on equity shares. A non-participating share is entitled to fixed rate of dividend only. They do not have such rights to participate or claim for a part in the surplus profits of a company.

Advantages of Preference Shares

There are certain advantages of preference shares from the investors point of view. The advantages are as follows: I. Fixed regular income: The culminative preference share investors even in case of absence of profits for the company get a regular hold of profits. The areas of dividends are generated in the years of profits of the company. II. Safety of interest voting rights: Voting rights are exerted by the investors in cases relating to the safety of interests. The interests of the preference shareholders are thus safeguarded. III. Less capital losses: The preference shareholders possess the preference rights of the repayment of their capital as a result of which there are less capital losses. IV. Proper security: Preference shareholders possess proper security in case of their shares in cases when the company fails to generate profits. V. Presence of preferential rights: When it comes to payment of dividend and repayment of capital, preference shareholders enjoy preferential rights. There are certain disadvantages of preference shares from the investors point of view. The advantages are as follows: VI. Absence of voting rights: Except in matters directly affecting their interests, the preference shareholders have no rights when it comes to voting on behalf of the company. VII. Absence of guarantee over assets: As in the case of debentures, the company provides no guarantee on the assets of the preference shareholders too. VIII. Fixed income: There is a fixed income that is generated for the preference shareholders. In cases where the company generates exceptional profits, these are by no means shared with the preference

shareholders. It is thus obvious that the preferential shareholders have no claim over the surplus of the company

Disadvantages of Preference Shares

The disadvantages of preference shares, from the point of view of the company are as follows: 1. High rate of dividends: The Company has to pay higher rates of dividends to the preference shareholders as compared to the common shareholders. Thus the cost of capital of the company is also increased. 2. Dilution of claim over assets: Because of the very reason that preference shareholders have preferential rights over the company assets in case of winding up of the company, dilution of equity shareholders claim over the assets take place. 3. Tax disadvantages: In case of preference shareholders, the taxable income of the company is not reduced while in case of common shareholders, the taxable income of the company is reduced. 4. Effect on credit worthiness: In case of preference shares, the credit worthiness of a company is definitely reduced because preference shareholders possess the right over the personal assets of the company. 5. Increase in financial burden: Because most of the preference shares issued is cumulative, the financial burden on the part of the company increases vehemently. The company also reduces the dividends of the equity shareholders because of the reason that it is essential on the part of the company to pay the dividends to the preference shareholders.

Conditions for redemption of preference shares

Before going to redeem the preference shares as per section 80 of the Companies Act, 1956, a company should have to follow the conditions: i) ii) iii) iv) v) vi) vii) There must be a provision in the Articles of Association regarding the redemption of preference shares. 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. 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. 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. The proceeds from fresh issue of debentures cannot be utilized for redemption. The amount of capital reserve cannot be used for redemption of preference shares. 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.

So, you may understand that a company must follow the above conditions for the purpose of redemption of its redeemable preference shares. In the next section we shall discuss about the Capital Redemption Reserve account.

Capital Redemption Reserve (CRR) Account

If you go through the conditions as discussed in the previous section, it will be clear that, if the preference shares are redeemed out of accumulated profit, it will be necessary to transfer an amount equal to the amount repaid on the redemption to Capital Redemption Reserve Account. If the company issues any fresh shares for redemption purpose, the transferred amount will be the difference between nominal value of shares redeemed and the nominal value of shares issued (i.e. amount transferred to CRR = Nominal value of shares redeemed Nominal value of shares issued). The capital redemption reserve account can be used for issuing fully paid bonus shares. The importance of creation of capital redemption reserve account is to a) protect the interest of creditors and b) maintain working capital. Redemption of preference shares involves repayment of capital before paying creditors of the company. It may affect the interest of creditors. In addition to that the working capital of the company will be depleted as a result of outflow of cash due to redemption. The amount is capitalized by creating the capital redemption reserve account. As a result this amount will not be available for distribution of dividend. It helps protect the interest of creditors and on the other hand it replenishes working capital.