According to financial theory, preference capital is one type of financing.
Preference capital carries preference to the shareholders at the time of winding up of company and dividend payment.
The preference capital is also referred to as the capital contributed by the preference shareholders. The preference shareholders receive dividends in the fixed rate but they do not enjoy voting rights.
Every business may be in the need of financing in order to meet the cost of new projects. The various means of financing are – share capital, debenture capital, term loan, deferred credit and IOU incentive sources.
The share capital may be further divided into two parts – equity capital and preference capital.
The concept of preference capital financing is believed to be the hybrid of two financing forms that are – debenture financing and equity financing.
Like equity financing, in the preference capital financing also the preference dividends are paid depending on the distributable profit and the preference dividends are not obligatory payments. Like equity dividends, the preference dividends are also not tax-deductible.
The similarities of preference capital with debenture are – preference capital is redeemable, preference capital dividend rate is fixed and the preference shareholders cannot vote.
The various features of preference capital are:
Participation in surplus profits and assets
The advantages of preference capital are:
Preference capitals are usually considered as a part of the net worth.
There is no legal obligation for the company to pay the preference dividends.
Usually preference shares do not carry voting rights.
Financial distress due to obligation of redemption is not high in preference capital because the periodic sinking fund payments are not needed.
No assets need to be pledged favoring the preference shareholders.
The disadvantages of preference capital are:
The preference capitals can be very expensive financing source while compared with debt financing.
The preference shareholders enjoy prior claims on the earnings and assets of the company.
Skipping dividend payment may affect the image of the company adversely.
The preference shareholders may gain voting rights if the company skips dividends for a period of time.