Introduction to ownership Securities, Ordinary Shares, Reference Shares
Introduction to ownership Securities, Ordinary Shares, Reference Shares: The issue of shares is the best method for the procurement of fixed capital requirements because it has not to be paid back to shareholders within the lifetime of the company. Funds raised through the issue of shares provide a financial floor to the capital structure of a company.
A share may be defined as a unit of measure of a shareholder’s interest in the company. “A share is a right to participate in the profits made by a company while it is a going concern and in the assets of the company when it is wound up.” (Bachan Cozdar Vs. Commissioner of Income tax). The share capital of the company is divided into a large number of equal parts and each part is individually called a share.
Under the provisions of Section 86 of the Indian Companies Act, 1956, a public company or a private company that is a subsidiary of a public company can issue only two types of shares i.e. equity shares and preference shares. However, an independent private company can issue deferred shares as well.
Preference Shares:
Preference Shares are those shares that carry priority rights with regard to payment of dividends and return of capital.
According to Sec. 85 of the Indian Companies Act, a preference share is that part of the share capital of the company which is endowed with the following preferential rights:
(1) Preference with regard to the payment of dividends at a fixed rate; and
(2) Preference as to repayment of capital in the event of the company being wound up.
Thus, Preference shareholders enjoy two preferential rights over the equity shares. Firstly, they are entitled to receive a fixed rate of dividend out of the net profits of the company prior to the declaration of dividend on equity shares.
Secondly, the assets remaining after the payment of debts of the company under liquidation are first distributed for returning preferential capital (contributed by the preference shareholders).
Types of Preference Shares:
(i) Cumulative and non-cumulative preference shares:
The holders of cumulative preference shares are sure to receive dividends on the preference shares held by them for all the years out of the earnings of the company. Under this the amount of unpaid dividend is carried forward as arrears and becomes the charge on the profits of the company.
If in any particular year they are not paid a dividend, they will be paid such arrear in the next year before any dividend can be distributed among the equity shareholders. But the non-cumulative preference shareholders are entitled to their yearly dividend only if there is sufficient net profit in that year. In case the earnings are not adequate, dividends are not paid and the unpaid dividend is not carried forward for payment out of profits in subsequent years.
(ii) Participating and non-participating preference shares:
The holders of these preference shares are entitled to a fixed rate of dividend and in addition, they are also granted the right to share the surplus net profits of the company, left after paying a certain rate of dividend on equity shares. Thus, participating shareholders obtain a return on their investments in two forms (a) fixed dividend and (b) share in surplus profits.
The preference shares which do not carry the right to share in the surplus profits are known as non-participating preference shares.
(iii) Redeemable and irredeemable preference shares:
Redeemable preference shares are those which, in accordance with the terms of issue, can be redeemed or repaid after a certain date or at the discretion of the company. The preference shares which cannot be redeemed during the lifetime of the company are known as irredeemable preference shares.
(iv) Convertible and non-convertible preference shares:
If the preference shareholders are given the option to convert their shares into equity shares within a fixed period of time such shares will be known as convertible preference shares. The preference shares which cannot be converted into equity shares are called non-convertible preference shares.
(v) Guaranteed Preference Shares:
In case of conversion of a private concern into a limited company or in case of amalgamation and absorption, the seller guarantees a particular rate of dividend on preference shares for certain years. These shares are called guaranteed preference shares.
Introduction to ownership Securities, Ordinary Shares, Reference Shares
Advantages of preference shares:
(1) Suitable to Cautious Investors. Preference shares mobilize the funds from such investors who prefer the safety of their capital and want to earn income with greater certainty.
(2) Retention of Control. Control of the company is vested with the management by issuing preference shares to outsiders because such share-holders have restricted voting rights.
(3) Increase in the Income of Equity Shareholders. Preference shares bear a fixed yield and enable the company to adopt the policy of “trading on equity” to increase the rate of dividend on equities out of profits remaining after paying a fixed rate of dividend on preference shares.
(4) Flexibility in the Capital Structure. In the case of redeemable preference shares, the company may feel at ease to bring flexibility in the financial structure as they can be redeemed whenever a company desires.
(5) No charge on Assets of the Company. The company can raise capital in the form of preference shares for the long term without creating any charge on its assets.
Disadvantages of preference shares:
(1) Permanent Burden:
Preference Shares Impose a permanent burden on the company to pay a fixed dividends prior to its disbursement among other types of shareholders.
(2) No Voting Right:
The preference shares may not be advantageous from the point of view of investors because they do not carry voting rights.
(3) Redemption during the period of Depression:
Preference shareholders will suffer the loss if the company exercises its discretion to redeem the debentures during periods of depression.
(4) Costly:
Compared to debentures and Govt., securities, the cost of raising the preference share capital is higher.
(5) Income Tax:
Since preference dividend is not an admissible deduction for income tax purposes, the company has to earn more, otherwise, the dividend on equity shareholders will be affected.
Ordinary Shares/Equity Shares:
Equity shares or ordinary shares are those ownership securities which do not carry any special right in respect of annual dividends or the return of capital in the event of winding up of the company.
According to Sec. 85(2) of the Indian Companies Act.
“Equity shares (with reference to any company limited by shares) are those which do not preference shares”. A substantial part of the risk capital of a company is raised from this source, which is of permanent nature.
Equity shareholders are the real owners of the company. They get dividends only after the dividend on preference shares is paid out of the profits of the company. They may not receive any return, if there are no profits. At the time of winding up of the company, equity capital can be paid back after every claim including that of preference shareholders has been settled.
According to Hoagland, ‘ ‘Equity shareholders are the residual claimants against the assets and income of the corporation.”The financial risk is more with equity share capital. So equity shares are also called “Risk Capital.”
As the equity shareholders have a higher risk, they also have a chance of getting higher dividends if the company earns higher profits. Equity shareholders control the affairs of the company because by possessing the voting rights they elect the directors of the company.
Advantages of Equity Shares:
(1) No Charge on Assets:
The company can raise the fixed capital without creating any charge over the assets.
(2) No-Recurring Fixed Payments:
Equity shares do not create any obligation on the part of the company to pay a fixed rate of dividend.
(3) Long-term Funds:
Equity capital constitutes the permanent source of finance and there is no obligation for the company to return the capital except when the company is liquidated.
(4) Right to Participate in Affairs:
Equity shareholders, being the real owners of the company, have the right to participate in the affairs of the company.
(5) Appreciation in the value of Assets:
Investors in equity shares are rewarded by handsome dividends and appreciation in the value of their shareholdings under boom conditions.
(6) Ownership:
Equity shareholders are the real owners of the company. They alone have voting rights. They elect the directors to manage the company.
Disadvantages of Equity Shares:
(1) Difficulty in Trading on Equity:
The company will not be in a position to adopt the policy of trading on equity if all or most of the capital is raised in the form of equity shares.
(2) Speculation:
During the period of boom, higher dividends on equity shares result in the appreciation of the value of shares which in turn leads to speculation.
(3) Manipulation:
As the affairs of the company are controlled by equity shareholders on the basis of voting rights, there are chances of manipulation by a powerful group.
(4) Concentration of Control:
Whenever the company intends to raise capital by new issues, priority is to be given to existing shareholders. This may lead to the concentration of power in few hands.
(5) Less Liquid:
Since equity shares are not refundable they are treated as illiquid.
(6) Not always Acceptable:
Because of the uncertainty of the return on the equity shares, conservative investors will hesitate to purchase them.
Deferred Shares:
The shares which are issued to the founders or promoters are called deferred shares or founders shares. The promoters take these shares for enabling them to control the company. These shares have extraordinary rights through their face value is very low.
The holders of deferred shares can get dividends only after preference and equity shareholders shall have received their dividends.
Nowadays, these shares have lost their popularity. At present in India, public companies cannot issue deferred shares.