What Is Redeemable Preference Shares?
Redeemable preference shares are a type of preferred stock that the issuing company has the right, but not the obligation, to repurchase or "call back" from shareholders at a predetermined price and date, or within a specified period. These shares represent an equity stake in a company but possess characteristics that blur the lines between traditional equity and debt instruments, placing them within the broader category of corporate finance. Unlike common shares, redeemable preference shares typically offer their shareholders a fixed dividends payment, which takes precedence over dividends paid to common shareholders.
History and Origin
The concept of preference shares, from which redeemable preference shares evolved, dates back to the 18th and 19th centuries. Initially, these instruments served as a form of "temporary rescue capital" for companies facing financial distress, offering a way to raise funds when traditional avenues were unavailable. Over time, their utility expanded, moving beyond mere rescue capital to become a staple component of a company's capital structure for financially stable entities seeking flexible financing. Finance Unlocked4
Key Takeaways
- Redeemable preference shares offer the issuing company the option to buy them back, typically at a specified price and time.
- Holders of redeemable preference shares generally receive fixed dividend payments, paid before any dividends on common shares.
- These shares typically carry limited or no voting rights for shareholders.
- In the event of a company's liquidation, redeemable preference shareholders have a higher claim on assets than common shareholders but are subordinate to bondholders.
- The redemption feature provides financial flexibility for the issuing company but introduces reinvestment risk for the investor.
Interpreting Redeemable Preference Shares
Redeemable preference shares are interpreted primarily through the lens of their fixed dividend yield and their redemption feature. For investors, they offer a predictable stream of fixed income, making them attractive to those seeking regular payouts rather than significant capital appreciation. The callable nature means the investor's tenure with the investment is not guaranteed. From the issuing company's perspective, the redemption clause provides flexibility in managing its capital, allowing it to reduce its dividend obligations if market interest rates decline or if it no longer requires the capital.
Hypothetical Example
Consider "Horizon Corp." that issues 100,000 redeemable preference shares with a par value of \$100 each, offering an 8% fixed annual dividend. The terms state that Horizon Corp. may redeem these shares at \$105 per share after five years from the issuance date.
An investor, Sarah, purchases 1,000 of these redeemable preference shares for \$100,000. Each year, she receives \$8,000 in dividends (1,000 shares * \$100 par value * 8%).
Five years later, Horizon Corp.'s financial performance has improved significantly, and prevailing interest rates have fallen. The company decides to exercise its option to redeem the shares. Sarah receives \$105 per share, totaling \$105,000 for her 1,000 shares, in addition to the dividends she has received over the five years. This example illustrates how the redemption clause affects both the company's ability to manage its finances and the investor's return.
Practical Applications
Redeemable preference shares are commonly used by companies as a flexible financing tool within their capital structure. They are often issued to raise capital for specific projects, expansions, or to refinance existing debt, without diluting the voting power of common shares. For instance, a real estate investment trust (REIT) like Annaly Capital123