Preference capital represents a hybrid form of financing – it takes some characteristics of equity and some attributes of debentures.
It resembles equity in the following ways:
- (i) Preference dividend is payable only out of distributed profits
- (ii) Preference dividend is not an obligatory payment (the payment of preference dividend is entirely within the discretion of the directors)
Preference capital is similar to debentures in several ways:
(i) The dividend rate of preference capital is usually fixed
(ii) The claim of preference shareholders is prior to the claim of equity shareholders
(iii) Preference shareholders do not normally enjoy the right to vote
ADVANTAGE AND DISADVANTAGE OF PREFERENCE CAPITAL
Preference Capital has the following Advantages:
1) There is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips preference dividend.
2) There is no redemption liability in the case of perpetual preference shares. Even in the case of redeemable preference shares, financial distress may not be much because:
(i) Periodic sinking fund payments are not required
(ii) Redemption can be delayed without significant penalties
3) Preference capital is generally regarded as part of net worth. Hence, it enhances the creditworthiness of the firm.
4) Preference shares do not, under normal circumstances, carry voting right. Hence, there is no dilution of control.
Preference Capital, however suffers from some serious shortcomings:
1) Compared to debt capital, it is an expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense.
2) Though there is no legal obligation to pay preference dividends, skipping them can adversely affect the image of the firm in the capital market.
3) Compared to equity shareholders, preference shareholders have a prior claim on the assets and earnings of the firm.
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