Advantages and Disadvantages of Preference Shares

Preference shares are hybrid financing instruments having several benefits and disadvantages for using them as a source of capital. Benefits are in the form of absence of legal obligation to pay dividend, improves borrowing capacity, saves dilution in control of existing shareholders and no charge on assets. Major disadvantage is that it is a costly source of finance and has preferential rights everywhere.

Advantages and Disadvantages of Preference SharesPreference shares are used by big corporate as a long term source of funding their projects. They are known as hybrid financing instruments because they share attributes of both equity and debt. It is important to analyze the benefits and disadvantages affixed with using preference shares as a medium of financing.

BENEFITS OF PREFERENCE SHARE

There are several benefits of a preference share from the point of view of a company which are discussed below:

No Legal Obligation for Dividend Payment: There is no compulsion of payment of preference dividend because nonpayment of dividend does not amount to bankruptcy. This dividend is not a fixed liability like the interest on the debt which has to be paid in all circumstances.

Improves Borrowing Capacity: Preference shares become a part of net worth and therefore reduces debt to equity ratio. This is how the overall borrowing capacity of the company increases. 

No dilution in control: Issue of preference share does not lead to dilution in control of existing equity

shareholders because the voting rights are not attached to issue of preference share capital. The preference shareholders invest their capital with fixed dividend percentage but they do not get control rights with them.

No Charge on Assets: While taking a term loan security needs to be given to the financial institution in the form of primary security and collateral security. There are no such requirements and therefore the company gets the required money and the assets also remain free of any kind of charge on them.

DISADVANTAGES OF PREFERENCE SHARES

Costly Source of Finance: Preference shares are considered a very costly source of finance which is apparently seen when they are compared with debt as a source of finance. The interest on debt is a tax deductible expense whereas the dividend of preference shares is paid out of the divisible profits of the company i.e. profit after taxes and all other expenses. For example the dividend on preference share is 9% and interest rate on debt is 10% with prevailing tax rate of 50%.

The effective cost of preference is same i.e. 9% but that of the debt is 5% {10% * (1-50%)}. The tax shield is the main element which makes all the difference. In no tax regime, the preference share would be comparable to debt but such a scenario is just an imagination.

Skipping Dividend Disregard Market Image: Skipping of dividend payment may not harm the company legally but it would always create a dent on the image of the company. While applying for some kind of debt or any other kind of finance, the lender would have this as a major concern. Under such a situation, counting skipping of dividend as an advantage is just a fancy. Practically, a company cannot afford to take such a risk. 

Preference in Claims: Preference shareholders enjoy similar situation like that of an equity shareholders but still gets a preference in both payment of their fixed dividend and claim on assets at the time of liquidation.