A company can use many ways to raise capital or funding for projects, campaigns, products, or expansions. The most common of them, of course, is debt and equity issues.
Huge corporations can decide what kind of issue to offer to the public, depending on type of relationship they want with the shareholders.
When it comes to that decision, some companies choose to issue preference shares apart from common shares and corporate bonds. The reasons behind such decisions may vary among companies.
What are Preference Shares?
Preference shares are like a hybrid between common shares and bond issues. Similar to any product or services, companies issue these shares because there is demand for them.
Investors invest in preference shares because of their relative stability and the preferred status over common shareholders. The dividend payments are also very appealing.
For corporations, preference shares are a way of equity financing minus the dilution of voting rights. They are also callable. Preference shares can also be used as a tool against hostile takeovers.
More often than not, preference shares compose a minority of a corporation’s debt issue. This is because preference shares are pretty confusing for many investors. And this limits the demand.
At the same time, stocks and bonds are usually adequate options for financing. They do the job pretty well.
Preference Shares for Investors
Most investors invest in preference shares because of their appealing dividend payments minus the long maturity dates found in bonds. They also don’t have to worry too much about too much volatility, which is found in common stocks.
The company, however, can remove the dividend payment if it experiences a period of super tight cash flow, or any other financial difficulties, for that matter.
This characteristic of preference shares provides maximum flexibility to the company since it won’t have to worry about missing a debt dividend payment.
With bonds, missing payments means the company is at risk of defaulting on the issue. Eventually, this could lead to forced bankruptcy.
Preferred shareholders also sometimes have the right to convert their preferred stock into common stock at a predetermined exchange price.
In case of a bankruptcy, the preferred shareholders receive company assets or payments before the common shareholders.
Preference Shares of Companies
Even though preference shares behave similarly to bond issues, it’s still an equity issue. And companies that offer equity issues more than debt issues can achieve lower debt-to-equity ratio.
And a lower debt-to-equity ratio means greater leverage since that ratio has something to do with the future financing needs from new investors.
A company’s debt-to-equity ratio is one of key metrics to analyze the financial status of a company. With lower debt-to-equity ratio comes more attractiveness to the business in the eyes of the investors.
At the same time, bond issues can be treated negatively by potential buyers because of the strict schedule of repayments for debt obligations.
Corporations may also find the callability of preference shares very appealing. Most preference stocks are callable. After a specific date, the issuer of the preference shares can call them at par value to avoid significant interest rate risk or opportunity cost.