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Preference Shares

Definition

Preference shares, also known as preferred stocks, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are paid out. They also have a higher claim on the company’s assets and earnings. This type of share typically does not carry voting rights, but it provides a higher claim on assets and earnings.

Phonetic

The phonetics for the keyword “Preference Shares” would be: /ˈprɛfərəns ʃerz/

Key Takeaways

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  1. Preference Shares or preferred stocks provide their owners with specific rights over and above those provided to common stockholders. These rights often include guaranteed dividends and preferential rights to the company’s assets in case of bankruptcy.
  2. Investors may prefer preference shares because these shares typically pay a regular dividend. This provides a stable stream of income, which is particularly beneficial for income-focused investors. Moreover, preference shareholders are compensated before common shareholders during the liquidation of a company’s assets.
  3. Despite these advantages, Preference Shares have limitations too. They do not usually carry voting rights. Besides, the dividends of preferred shares can be skipped by the company in some situations without the risk of bankruptcy.

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Importance

Preference shares, also known as preferred stock, are an important aspect of business/finance because they offer a unique combination of characteristics of both equities and bonds. They are crucial for investors who prefer lower risk and guaranteed returns, as they typically provide a fixed dividend and have a higher claim on company assets and earnings than common shares. These shares also hold an advantageous position in the dissolution of a company. If the company ever goes bankrupt, preference shareholders will receive their share of the remaining assets ahead of common shareholders. This type of share can be a vital part of a company’s capital structure and can offer both the company and the investor financial flexibility by meeting their specific needs and risk profiles.

Explanation

Preference Shares, also known as Preferred Shares, play a critical role in corporate finance by providing companies with an alternative method to raise capital. Unlike common shares, preference shares have characteristics of both equity and debt financing. They are often used by companies seeking to raise capital without diluting voting rights, as preference shareholders typically don’t have voting rights. This makes preference shares an attractive option for businesses aiming to maintain control while still gaining the funding needed for expansion, debt repayment, or funding other business operations.In terms of benefits for investors, preference shares provide a fixed-income stream, often paying out dividends at a set rate, which is appealing to those seeking a regular return on their investment. These shares carry less risk than common shares as they have a higher claim on the company’s assets and earnings. In the event of bankruptcy or liquidation, preference shareholders are paid dividends and the return of capital before common shareholders. Thus, preference shares serve a crucial purpose in providing a strategic investment option with both income and security features.

Examples

1. Google: In 2014, Google made a move to create Class C shares, which did not have any voting rights. This was done to ensure that the company’s founders maintained control over the decision-making process in the firm. These Class C shares could be described as a form of preference shares as they were being issued with different rights than the Class A and B shares.2. Berkshire Hathaway: Warren Buffet, Chairman and CEO of Berkshire Hathaway, famously employs preferred stocks in his investment strategies. One notable instance is during the 2008 financial crisis when Goldman Sachs was in need of capital, Berkshire Hathaway bought $5 billion worth of preferred stocks that carried a 10% dividend. This assured Berkshire Hathaway of a guaranteed dividend irrespective of Goldman Sachs’ performance. 3. Ford Motor Co: In 2012, Ford Motor Company issued ‘Convertible Preferred Shares’ which paid a dividend but also gave investors the right to convert these shares into regular common stock under certain conditions. The move was aimed at raising capital while reducing cash outflow through dividends as the dividends on preferred shares were lesser than regular shares.

Frequently Asked Questions(FAQ)

What are Preference Shares?

Preference Shares, also known as Preferred Stock, is a type of equity or share, which gives its holders the right to receive dividends before any dividends are paid to ordinary shareholders. It comes with superior entitlements compared to common shares like priority payment of dividends and return of capital.

How are Preference Shares different from Ordinary Shares?

The key difference between Ordinary Shares and Preference Shares is in the priority of payment. Preference Shareholders have a higher claim on the assets and earnings of the company. They receive dividends before Ordinary Shareholders and have a fixed dividend rate.

Are Preference Shareholders entitled to voting rights?

Generally, Preference Shareholders do not hold voting rights in the company. However, voting rights may be given depending on the terms of the issuance of the Preference Shares.

Can Preference Shares be converted into Ordinary Shares?

Yes, some types of Preference Shares, known as Convertible Preference Shares, come with an option for the holder to convert them into a specified number of Ordinary Shares at specific times during the life of the shares.

What happens when a company goes bankrupt? Who gets paid first?

In the event of a company’s bankruptcy, Preference Shareholders get priority over Ordinary Shareholders during the distribution of the remaining assets after creditors have been paid off.

Why would a company issue Preference Shares?

A company may choose to issue Preference Shares over borrowing as it is a way to raise capital without incurring debt. Also, since Preference Shares typically do not carry voting rights, it allows a company not to dilute control while raising capital.

Are Preference Shares a good investment?

It depends on the investor’s individual financial goals. Preference Shares often provide a consistent income source, making them attractive to income-focused investors. However, they generally lack the capital appreciation potential of ordinary shares.

Related Finance Terms

  • Dividend Rights
  • Voting Rights
  • Convertible Preference Shares
  • Cumulative Preference Shares
  • Redeemable Preference Shares

Sources for More Information

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