A Guide to Basics of Preference Shares / Preferred Shares

The current article provides responses related to Preference shares/Preferred shares:

• Explanation of various terms associated with preference shares
• Is it debt or equity?
• Where do the companies show their issuance and redemption in the balance sheet and the P&L?

Various Terms associated with Preference Shares / Preferred Shares

Hi Vijay,

Hope you are doing well. I was one of the participants in your “Peaceful Investing” workshop in Pune. I have a few questions about redeemable preference shares.

1. What are the effects of redeemable preference shares on the capital of a company when these shares mature?
2. How do companies generally deal with the maturity of redeemable preference shares? Do they issue fresh equity, bonus or redeem with undistributed profits?
3. So for an example, for a company that has issued 7% redeemable cumulative preference shares (worth say ₹40 cr) redeemable at par maturing in 10 years (say in March 2018), what options does a company have in order to redeem these shares? How do these options stack up in terms of preference or general practice in the industry and what will be the impact on the capital structure of the company on maturity?

Would appreciate your thoughts and insights on this.

Regards

Author’s Response:

Hi,

Thanks for writing to us!

The fate of the preferred shares along with their impact on capital differs from case to case depending upon the terms of each issued case of preferred shares:

1. If the coupon is mentioned and is non-cumulative that would mean regular interest payments like regular debenture.
2. If the coupon is cumulative, then the entire coupon can be paid at maturity
3. If a premium is mentioned, then preferred shares would be redeemed at a price higher than par value at maturity (Par Value + Premium Value)
4. If no premium is mentioned, then preferred shares would be redeemed at a price equal to par value
5. If it is convertible, then it would depend upon whether it is compulsory or optionally convertible. In the compulsory convertible, the company would not pay anything on maturity and would issue new equity shares, which would get the same rights as existing common shares. In optionally convertible, the preferred shares subscriber might or might not choose to convert preferred shares into equity shares. If the preferred shares Subscriber decides to not convert, then the maturity amount would be paid to her without any impact on equity capital structure.
6. Conversion can be fully or partially, in such cases of fully convertible all the preferred shares on maturity would be convertible into equity shares and no cash outflow. In partially convertible, then as per terms of the agreement, the preferred shares subscriber can convert part of preferred shares into equity shares and get the balance as cash from the company on maturity.

Further Reading: Understanding The Annual Report Of A Company

Therefore, in each case of different types of preferred shares, the final impact would be different depending upon the terms of the specific preferred shares agreement between the company and the subscriber.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Follow up Query:

Thank you for your response and this information Vijay. Some follow-up questions. In the case of redeemable preferred shares:

1. Are these considered part of overall outstanding shares or considered as debt?
2. If considered as part of overall outstanding shares, what happens on the maturity of such preferred shares, does the share capital reduce by the par value of the preference shares redeemed (unless redeemed by issuing fresh equity?)
3. How do companies pay back the investors holding redeemable preferred shares on maturity? What is the most preferred strategy adopted by companies to redeem such preferred shares?

Regards

Author’s Response:

Hi,

Thanks for writing to us!

1) Are these considered part of overall outstanding shares or considered as debt?

Preferred shares are treated as part of outstanding share capital

2) if considered as part of overall outstanding shares, what happens on the maturity of such preferred shares, does the share capital reduce by the par value of the preference shares redeemed (unless redeemed by issuing fresh equity?)

At maturity, the paid-up share capital reduced to that extent.

3) How do companies pay back the investors holding redeemable preferred shares on maturity? What is the most preferred strategy adopted by companies to redeem such preferred shares?

Redemption method depends on the type of preferred shares and its terms as discussed in the previous answer.

Further Reading: How to do Financial Analysis of Companies

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Accounting treatment of Preference Shares / Preferred Shares

Hi,

I have noticed that one of the companies, which I hold has put out the following agenda for voting:

(c) Redemption of 250,000 Zero Percent Redeemable Non- Cumulative, Non- Convertible, Nonparticipating Preference Shares of Re. 1/- Each aggregating to Rs 250,000 only.

I am not able to understand what does it mean? I know in terms of bonds Redemption means company returning money back on maturity but what does it really mean in terms of shares at par value.

Thanks,

Author’s Response:

Hi,

Thanks for writing to us!

Redemption means repaying/settling the liability. We have clarified other terms of these preferred shares in the answer to the query above.

Moreover, reading the annual reports would provide more information to you whether any other term also gets triggered along with redemption.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Follow up Query:

Thank you very much. Not only have I learned a great deal of finance from you but also lots of humility.

As per the details in the meeting minutes uploaded by the company on the NSE website, it looks like they gave 250,000 Zero Percent Redeemable Non- Cumulative, Non- Convertible, Nonparticipating Preference Shares at Rs 1 to raise money for the working capital requirement and now as they have surplus cash in balance sheet they have decided to cash it back.

Now my understanding is that this seems like at buyback? The ₹2.5 lac will go out from the P&L and total outstanding shares should go down as well?

This is the company I am long on.

Thanks,

Author’s Response:

Hi,

Thanks for writing to us. We are happy that you found the articles useful.

As per the NSE filing and the detailed provided by you, it seems that the Rs. 250,000/- is an interest-free loan structured in the form of these preferred shares, which the company is now repaying.

However, the annual report of the company for FY2016 (pg. 37) mentions these preferred shares as 5% interest bearing. We would request you to get this discrepancy clarified from the company.

Further Reading: Understanding The Annual Report Of A Company

If the preferred shares do not have any voting rights, then even though the paid-up capital would reduce, still it would not be equivalent to buyback of common shares as the shares bearing voting rights are unchanged and the EPS would also remain unchanged.

Non-convertible preferred shares are mostly like a loan.

Also, the accounting entries would not impact the Profit and Loss statement. The impact on the balance sheet would be: 1) Asset side: reduction of cash by Rs. 250,000/- 2) Liability side: reduction of shareholder’s funds (equity + reserves) by Rs. 250,000/-

Further Reading: How to do Financial Analysis of Companies

We do not have any views on this company.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.