What are Preference Shares?

S7-SA7-0309

Grade Level:

Class 12

AI/ML, Physics, Biotechnology, FinTech, EVs, Space Technology, Climate Science, Blockchain, Medicine, Engineering, Law, Economics

Definition

What is it?

Preference shares are a special type of share that gives their owners certain 'preferential' rights over regular shareholders. These rights usually involve receiving a fixed dividend payment before ordinary shareholders and getting their money back first if the company closes down.

Simple Example

Quick Example

Imagine a school cricket match where some players are given a special rule: they always bat first and if the match is called off due to rain, they get their snacks first. Preference shareholders are like those special players. They get their share of profits (dividends) first, similar to how those players bat first, and if the company faces trouble, they get their investment back before others, just like getting snacks first.

Worked Example

Step-by-Step

Let's say a company, 'Bharat Bikes Ltd.', makes a profit of ₹10,00,000.
--- Bharat Bikes has 10,000 preference shares, each with a fixed dividend rate of ₹10 per share.
--- They also have 1,00,000 ordinary shares.
--- STEP 1: Calculate total dividend for preference shareholders. Total Preference Dividend = Number of Preference Shares x Dividend per share = 10,000 shares x ₹10/share = ₹1,00,000.
--- STEP 2: Pay the preference shareholders first. From the ₹10,00,000 profit, ₹1,00,000 is set aside for preference shareholders.
--- STEP 3: Calculate remaining profit for ordinary shareholders. Remaining Profit = Total Profit - Preference Dividend = ₹10,00,000 - ₹1,00,000 = ₹9,00,000.
--- STEP 4: This remaining ₹9,00,000 can then be distributed among the 1,00,000 ordinary shareholders. This means ordinary shareholders get ₹9 per share (₹9,00,000 / 1,00,000 shares).
--- ANSWER: Preference shareholders received their fixed ₹10 per share first, before ordinary shareholders received their ₹9 per share.

Why It Matters

Understanding preference shares is crucial for anyone interested in FinTech or Economics, as it helps analyze how companies manage their finances and attract investors. Future professionals in Investment Banking, Financial Analysis, or even starting their own EV or Biotechnology companies will deal with different types of shares to raise capital.

Common Mistakes

MISTAKE: Thinking preference shareholders get unlimited dividends if the company does very well. | CORRECTION: Preference shareholders usually get a fixed dividend amount, regardless of how high the company's profits are. Their dividend doesn't increase with higher profits.

MISTAKE: Believing preference shares give voting rights in company decisions, like ordinary shares. | CORRECTION: Generally, preference shareholders do not have voting rights in the company's general meetings, unlike ordinary shareholders who vote on important decisions.

MISTAKE: Confusing preference shares with debentures (loans). | CORRECTION: Preference shares are still part of the company's equity (ownership), while debentures are debt. Debenture holders are paid before even preference shareholders if a company closes.

Practice Questions

Try It Yourself

QUESTION: A company has 5,000 preference shares, each paying a fixed dividend of ₹20. If the company makes a profit of ₹2,00,000, how much will be paid to preference shareholders? | ANSWER: ₹1,00,000 (5,000 shares * ₹20/share)

QUESTION: 'Tech Innovations Ltd.' earned ₹5,00,000 profit. They have 10,000 preference shares (₹15 dividend per share) and 50,000 ordinary shares. How much profit is left for ordinary shareholders after preference dividends are paid? | ANSWER: ₹3,50,000 (₹5,00,000 - (10,000 shares * ₹15/share))

QUESTION: If a company has 2,000 preference shares with a 10% dividend rate on a face value of ₹100 per share, and 10,000 ordinary shares. If the company's total profit is ₹30,000, how much dividend does each ordinary share get? | ANSWER: Each preference share gets ₹10 (10% of ₹100). Total preference dividend = 2,000 * ₹10 = ₹20,000. Remaining profit for ordinary shares = ₹30,000 - ₹20,000 = ₹10,000. Each ordinary share gets ₹10,000 / 10,000 shares = ₹1.

MCQ

Quick Quiz

Which of the following is a key feature of preference shares?

They always have voting rights in the company.

They receive a fixed dividend payment before ordinary shareholders.

Their dividend increases directly with company profits.

They are a form of company debt, like a loan.

The Correct Answer Is:

Preference shares are known for their 'preferential' right to receive a fixed dividend before ordinary shareholders. They typically do not have voting rights, their dividends are usually fixed, and they are equity, not debt.

Real World Connection

In the Real World

When big Indian companies like Reliance Jio or Tata Motors want to raise money for new projects, like building more EV charging stations or developing new AI software, they might issue different types of shares. Preference shares can be attractive to investors who want a steady, predictable income without taking on too much risk, similar to how you might choose a fixed deposit for stable returns.

Key Vocabulary

Key Terms

DIVIDEND: A portion of company profits paid to shareholders | ORDINARY SHARES: Regular shares representing ownership, usually with voting rights and variable dividends | EQUITY: The value of ownership in a company | FACE VALUE: The nominal or par value of a share as stated by the company | LIQUIDATION: The process of closing down a company and selling its assets.

What's Next

What to Learn Next

Next, you should explore 'What are Ordinary Shares?' to understand the key differences and why companies issue both types. Then, you can learn about 'Debentures' to see how companies raise money through loans, which will give you a complete picture of company financing!