Benefits of Investing in Preference Shares Explained

Badal, a 12-year-old boy, saved ₹500 from his pocket money. He wanted to grow his money but did not know how. His father told him about investments. 

One day, Badal saw his uncle earn ₹50 every month from his investments. Curious, Badal asked, "How can ₹500 become more?" His uncle smiled and said, "Smart choices make money grow." 

Excited, Badal decided to learn more. He wanted his ₹500 to become ₹1,000 one day. How can Badal make his dream come true? We will explore this in the blog.

1. Fixed Income

Investing in preference shares offers a key benefit: fixed income. This means you receive regular dividend payments at a set rate. These dividends are paid before any are given to common shareholders, providing a steady and 

predictable income stream. This feature makes preference shares appealing to investors seeking consistent returns with lower risk.

Example:

Gaurav invested ₹1,00,000 in preference shares with a 7% dividend rate. Every year, he gets ₹7,000 as a fixed income. Even if the company earns less profit, Gaurav still receives his ₹7,000 before common shareholders. This helps him plan his expenses easily.

A simple table to illustrate:

This fixed-income aspect of preference shares is similar to bonds, offering a reliable return, especially suitable for conservative investors.

2. Tax Efficiency

Investing in preference shares can be tax-efficient. Dividends from these shares are taxed at your income tax slab rate. For example, if you earn ₹10,000 in dividends:

Compared to bonds, where interest income is fully taxable, preference shares may offer better after-tax returns, especially for investors in lower tax brackets.

Additionally, suppose you sell listed preference shares after holding them for more than one year. In that case, the gains are taxed at 10% without indexation benefits, or at 20% with indexation, whichever is more beneficial.

This tax efficiency makes preference shares an attractive option for investors seeking steady income with potential tax advantages.

Example:

Lalita earns ₹6,000 as dividend from preference shares. She falls under the 10% tax slab, so she pays ₹600 as tax. Her final income is ₹5,400. If she had earned the same from bonds, it would still be fully taxed. Later, she sells her shares after 1.5 years and pays just 10% on her profit. This way, Lalita saves more tax and earns more money.

3. Convertible Options

Investing in convertible preference shares offers flexibility and potential for higher returns. These shares provide fixed dividends and can later be converted into common shares, allowing investors to benefit from the company's growth.

A simple example:

In this scenario, you invest ₹1,000 in a convertible preference share and receive ₹50 annually as a fixed dividend. Later, you have the option to convert it into 10 ordinary shares. If each common share is worth ₹120 at that time, your total value becomes ₹1,200, resulting in a gain of ₹200.

Convertible preference shares benefit investors seeking steady income with the potential for capital appreciation. However, as the value of common shares can fluctuate, it is essential to consider the company's performance and market conditions before converting.

4. Liquidation Preference

Investing in preference shares offers a key benefit: liquidation preference. This means that if a company is sold or closed, preference shareholders are paid before common shareholders, providing added security for investors.

A simple example:

In this example, the investor first receives ₹2,00,000 due to the 1x liquidation preference. Then, they receive an additional ₹1,60,000 based on their 20% ownership of the remaining ₹8,00,000. This totals ₹3,60,000, providing both security and the potential for further returns.

Liquidation preference ensures that investors recover their initial investment before others, making preference shares a safer option during uncertain times.

5. Dividend Priority 

Investing in preference shares offers another key benefit: dividend priority. This means preference shareholders receive their fixed dividends before any dividends are paid to common shareholders. This priority provides a more stable and predictable income stream, making preference shares attractive to investors seeking consistent returns.

A simple example:

In this scenario, preference shareholders are entitled to receive ₹8,000 annually (8% of ₹1,00,000) before any dividends are distributed to common shareholders. Common shareholders receive dividends only after preference shareholders have been paid, and the amount can vary based on the company's profitability.

This dividend priority ensures that preference shareholders have a higher claim on the company's earnings, providing a level of income stability that is especially valuable during periods of fluctuating profits.

Conclusion

Preference shares give fixed income, tax benefits, and safety. Investors get dividends first and money back if the company closes. Some shares can turn into common shares for higher profits. They are good for steady income with lower risk. A smart choice for safe and stable returns.

FAQs

1. What are preference shares?

Preference shares give fixed dividends and priority over common shareholders.

2. Are preference shares safer than common shares?

Yes, they offer fixed income and are paid first in dividends and liquidation.

3. Can preference shares be converted into common shares?

Yes, convertible preference shares can be exchanged for common shares later.

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