Dividend on Preference Shares is Compulsory: Understanding the Basics
Preference shares are a type of equity security that provides its holders with preferential treatment over ordinary shareholders in terms of dividend payments and liquidation preferences. One of the key features of preference shares is the compulsory payment of dividends to preference shareholders. In this blog, we will discuss the basics of dividend on preference shares and the reasons behind the mandatory payment of dividends.
What are Preference Shares?
Preference shares are a type of equity security that provides its holders with preferential treatment over ordinary shareholders in terms of dividend payments and liquidation preferences. Preference shareholders are entitled to receive a fixed dividend at a specified rate, which is usually higher than the dividend paid to ordinary shareholders. In addition, preference shareholders have a priority claim over ordinary shareholders in case of liquidation or bankruptcy.
Types of Preference Shares
There are different types of preference shares, including cumulative and non-cumulative preference shares. Cumulative preference shares require the payment of all unpaid dividends before any dividend can be paid to ordinary shareholders. Non-cumulative preference shares do not have this requirement, and any unpaid dividends do not accumulate.
Why is Dividend on Preference Shares Compulsory?
The payment of dividends on preference shares is mandatory, and the company must pay the dividend before paying any dividend to ordinary shareholders. There are several reasons why dividend on preference shares is compulsory:
- Legal Obligation: The payment of dividend on preference shares is a legal obligation of the company. The terms and conditions of preference shares are laid out in the company’s articles of association, and failure to pay the dividend can result in legal action against the company.
- Protection of Investor Interests: Preference shareholders invest in the company with the expectation of receiving a fixed dividend at a specified rate. The compulsory payment of dividend protects the interests of these investors and ensures that they receive the return on their investment.
- Access to Capital: Companies issue preference shares to raise capital, and the compulsory payment of dividend makes these shares more attractive to investors. The payment of a fixed dividend at a specified rate provides investors with a predictable return on their investment, which is important in attracting capital.
- Creditworthiness: Companies that issue preference shares are considered more creditworthy as they have a stable source of funding. The compulsory payment of dividend on preference shares enhances the creditworthiness of the company and makes it easier for the company to access capital.
Benefits and Risks of Preference Shares
Preference shares offer several benefits to both companies and investors. Companies can use preference shares as a source of capital without diluting their ownership. Preference shares also provide the company with a stable source of funding, which enhances their creditworthiness. Investors, on the other hand, benefit from a fixed dividend payment and priority in case of liquidation or bankruptcy. However, preference shares also come with some risks. For example, the fixed dividend payment can make the shares less attractive in a rising interest rate environment, and the lack of voting rights can limit the investor’s ability to influence the company’s decision-making process.
Cumulative vs Non-Cumulative Preference Shares
Cumulative preference shares require the payment of all unpaid dividends before any dividend can be paid to ordinary shareholders. Non-cumulative preference shares do not have this requirement, and any unpaid dividends do not accumulate. The choice between cumulative and non-cumulative preference shares depends on the company’s financial position and the investor’s preference for risk and return. Cumulative preference shares provide more security to investors, while non-cumulative preference shares offer higher potential returns.
Redeemable vs Irredeemable Preference Shares
Redeemable preference shares can be redeemed by the company at a predetermined date or at the option of the investor. Irredeemable preference shares, on the other hand, have no maturity date and cannot be redeemed by the company. Redeemable preference shares provide companies with flexibility in managing their capital structure, while irredeemable preference shares provide investors with a long-term investment opportunity.
Conclusion
Preference shares offer several benefits to both companies and investors, including a fixed dividend payment and priority in case of liquidation or bankruptcy. However, preference shares also come with some risks, including limited voting rights and the fixed dividend payment that can make the shares less attractive in a rising interest rate environment. Companies and investors must carefully consider the features of preference shares and their financial position and objectives before investing or issuing preference shares.
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Frequently Asked Questions (FAQs)
What are preference shares?
Preference shares are a type of equity security that provides its holders with preferential treatment over ordinary shareholders in terms of dividend payments and liquidation preferences.
What is the difference between preference shares and ordinary shares?
Preference shares provide its holders with preferential treatment over ordinary shareholders in terms of dividend payments and liquidation preferences. Ordinary shares do not have any preferential treatment and have voting rights.
What is a fixed dividend on preference shares?
A fixed dividend on preference shares is a specified rate of dividend that is paid to preference shareholders. The dividend is usually higher than the dividend paid to ordinary shareholders.
Is dividend on preference shares compulsory?
Yes, dividend on preference shares is compulsory. The company must pay the dividend before paying any dividend to ordinary shareholders.
What are the types of preference shares?
There are different types of preference shares, including cumulative and non-cumulative preference shares, redeemable and irredeemable preference shares.
What is a cumulative preference share?
Cumulative preference shares require the payment of all unpaid dividends before any dividend can be paid to ordinary shareholders.
What is a non-cumulative preference share?
Non-cumulative preference shares do not have the requirement of the payment of all unpaid dividends before any dividend can be paid to ordinary shareholders.
What is a redeemable preference share?
Redeemable preference shares can be redeemed by the company at a predetermined date or at the option of the investor.
What is an irredeemable preference share?
Irredeemable preference shares have no maturity date and cannot be redeemed by the company.
What are the risks associated with preference shares?
The risks associated with preference shares include limited voting rights, fixed dividend payment that can make the shares less attractive in a rising interest rate environment, and the potential for a decrease in dividend payments in case of financial difficulties of the company.
