written by: Steve McFarlane•edited by: Jason C. Chavis•updated: 11/10/2010
There are many advantages of preference shares, and there are also a number of disadvantages. We take a closer look at both.
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In general, stock or share ownership gives the holder a right to a portion of the profits or losses of a company, but of course most will be keen on making a positive return on what they invested. Among the options investors have for owning a part of a company are preference shares. In this article we will look at what are the advantages of preference shares, as well as the disadvantages.
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Unlike ordinary shareholders, preference shareholders have a first claim on profits and the proceeds from the sale of a company assets if the company enters bankruptcy. This gives preference shareholders a significant advantage over ordinary shareholders in that ordinary shareholders cannot get a dividend payment until the preference shareholders are paid in full. Even so, preference shareholders are not guaranteed to receive a dividend every time, certainly not when the company doesn’t have the financial means to pay.
Another benefit of holding preference shares is the consistency with which interest payments are made. Of course, the terms of payment will vary among different shares, but payments are usually made on a set schedule (yearly or monthly), which can really help the investor to build a investment strategy around a consistent cash flow.
Perhaps one of the biggest advantages of trading in preference shares is derived by the issuing company.In many instances, preference shares are a better way to raise capital because the issuing company can determine what interest is paid for the debt as opposed to borrowing from a bank. Best of all, voting rights are not sold off to the investor as happenss when ordinary shares are issued. The issuer can also determine when the principal is repaid; in many cases the preference share is kept on the books indefinitely, with only the interest being paid.
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Disadvantages Of Preference Shares
One of the main disadvantages of holding preferences shares is that the returns are fixed; this imposes a restraint on growth potential of preference shares.In fact, preference shares have been called a hybrid of ordinary shares and bonds. So while these shareholders have a claim on company assets, their returns are restricted.
Therefore, it is quite possible, and often the case, that ordinary shareholders realize a greater return on their investment than preference shareholders, as in the case when the ordinary shares have appreciated significantly in value. When you add to this the fact that the preference shares issuer is under no contractual obligation to repay the debt by a fixed date one can understand why many investors don’t find investing in preference shares particularly attractive.
One should also be aware that preference shareholders do not have voting rights.Voting rights give shareholders influence over important decisions that are taken with regard to strategic alignments and operating positioning of a business. Not having this right will leave the investor with no power to directly influence the decisions that can affect his investment.However, not having these rights will not be a major issue for the minor shareholder who is just looking to make a return without influencing how the business is run.
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The major advantage that preference shareholders have is that they have a greater claim on a company’s profits and assets than do ordinary shareholders, but not more than the company’s creditors.
In addition, while preference shares generally have a fixed rate of return they don’t offer the growth potential of ordinary shares, neither is the issuer under a contractual obligation to return the principal to investors by a set time. Therefore preference shareholders are often left holding a low yielding investment instrument for a long period of time, especially if rates are trending upwards and no one wants to buy the lower yielding preference shares.