Business

Refinancing the balance sheet using preference shares

Contributed by CHRISTINA MILLINGTON

Sunday, August 24, 2014    

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PREFERRED shares are a hybrid security that share the characteristics of both common stocks and bonds, and offer a company an alternative form of financing.

The preference shareholder occupies a position between the company's creditors and the common shareholder. In the event of liquidation, preference shareholders are entitled to be paid from the liquidation of assets before ordinary shareholders. However, their claims are subordinate to the claims of secured creditors.

Similar to common stock, preference shares do not have a maturity date. They also entitle the holder to a fixed dividend payment which takes priority over ordinary share dividends. Nevertheless, this does not guarantee the payment of dividends, but a company must pay the stated dividends on preferred stock before paying any dividends on common stock. If a company does not pay the dividend, it is not considered to be in default as it would be if it missed a bond payment.

Features of a preference share

The balance sheet classification (debt or equity) of a preferred share is dependent upon its features. The features of a preference share are unique to the individual share, the most common of which are:

*Cumulative preference shares - this feature stipulates that if any dividends have been omitted in the past, they must be paid out to preferred shareholders first, before common shareholders can receive dividends.

*Non-cumulative preference shares - This does not pay the holder any unpaid or omitted dividends. If the company chooses not to pay dividends in a given year, the investor does not have the right to claim any of those forgone dividends in the future.

*Redeemable preference shares - This can be redeemed by the company either after a fixed time or at a time of either the company's or shareholder's choice. They are classified as non-current liabilities in the statement of financial position of a company.

*Non-redeemable preference shares - These are shares that will not be bought back by the company. Shareholders will continue to earn dividends as long as profit is earned. The principal balance is not repayable by the company, except in the event of liquidation or winding up of the company. They are classified as equity on the balance sheet.

*Convertible preference shares - This includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually any time after a predetermined date.

The advantages of using preference shares as a source of capital include no legal obligation to pay dividend, improving borrowing capacity, saving dilution in control of existing shareholders (if non-convertible), and no charge on assets.

Advantages of preferred stock to buyers

*Preferential Tax Treatment - Tax on dividends for preferred stock is treated similarly to dividends on common stock. As such, dividends received are taxed at 15 per cent, while interest received from a bond is taxed at 25 per cent. This, effectively, provides a higher rate of return.

*Provides Liquidity - If the preference share is listed on the Jamaica Stock Exchange, it can be readily traded in contrast to most debt issues that are not listed.

*Security of Principal - Greater claim on the Company's Assets in comparison to the Common Stock holder.

*Priority of Dividends - In order for an issuer to suspend the dividend payment on the preferred shares, they must first suspend all dividend payments for the common shareholders. It also provides a steady reliable income stream.

*If convertible, there is an opportunity to be a common shareholder if the company does well at a lower cost (the stock is normally convertible at a set price, so if the company does well you can cash in).

*If the company is doing well, preferred stock can appreciate independently if interest rates move.

*Cumulative preference shares guarantee dividend as opposed to ordinary dividend, which is discretionary.

Risks of preferred stock to the investor

Preferred shares can differ dramatically depending on their structure, yield, term, and credit quality. Therefore, when incorporating preferred shares into a portfolio, an investor needs to consider a number of factors in order to determine whether a particular preferred share is an appropriate investment.

*Preferred stock typically does not include the right to vote at the company's annual stockholders' meeting.

*The market price of preferred stock is interest-rate sensitive and can decrease sharply during periods of rapidly rising interest rates.

*Since the board of directors can elect to suspend dividend payments, there is no guarantee that preferred stock will maintain its regular stream of current income.

Disadvantages to the issuer

*It is a costly source of finance as preference shares are considered to be very costly when they are compared with debt as a source of finance. The interest on debt is a tax-deductible expense whereas the dividend of preference shares is paid out of the company's after-tax profits.

*Skipping dividend payments harms the company's market image though it may not harm the company legally.

In November 2013, Jamaica Public Service raised $2.5 billion issuing a 9.5 per cent cumulative non-redeemable preference share and Eppley Limited raised $300 million using a 9.5 per cent cumulative redeemable preference share. In August 2013, Jamaica Money Market Brokers raised $750 million using a 7.5 and 7.25 per cent cumulative preference share.

The capital structure decision affects financial risk and, inherently, the value of the company. Therefore, the goal of the capital structure decision is to determine the level financial leverage that maximises the value of the company (or minimises the weighted average cost of capital). Preference shares provide companies with an alternate source of financing.

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