Determine the Preference Shares - Equity Instruments

Sandwiched between equity share holders anddebt holders, preference share holders have promise of an assured dividend from company and thus presume less risk than that borne by equity share holders. They don't have any voting rights in the company.  When a company fails to pay the dividend to them for two years in a row, then these shares get a voting right.

Preference shares are issued by only those companies who are paying a very low level of tax.  Why? This is because though the returns desired by preference shareholders is at par with the returns offered by fixed deposits, the cost to the company is after tax in case of preference shares while the interest paid on fixed deposits is tax deductible.

So a company that is paying 10 per cent dividend on preference shares ends up paying 1 1 per cent (including 10 per cent dividend tax).  If company pays no income tax [as in the case of a 100 per cent Export Oriented Unit (EOU)] then this is the cost to company.  If company pays tax at the rate of 35 per cent then before tax cost shoots above 14 per cent. Compared with a debt cost of 7 to 12 per cent for established companies, it isn't a viable alternative at all to go in for preference shares if tax liabilities are high. Thus preference shares would only be issued if company requires a more permanent source of capital.

For investor the biggest benefit of investing in a preference share is that dividends are tax free in their hands. Which means if you are getting a dividend of 10 per cent from a preference share and you are in 30 per cent tax bracket, your net return is yet 10 per cent that is equivalent to receiving an interest income of 13 per cent from fixed deposits or any other interest bearing source.