A share is a unit of ownership in a company and has an exchangeable value influenced by market forces. As per Section 43 of the Companies Act, 2013, a company’s share capital is categorized into two types: equity shares and preference shares.
Preference Share Capital
Preference share capital is the money a company raises by issuing preference shares, which provide shareholders with specific rights. Preference shareholders have the first right to receive dividends before equity shareholders. Preference shares offer a unique combination of features that differentiate them from debt or common equity. These shares provide holders with priority over common stockholders in claiming the company’s assets upon liquidation and offer dividend payments.
Generally, preference shares do not grant voting rights to their holders; however, some allow voting on extraordinary events. Certain preference shares can be converted into a predetermined number of common shares. Some specify a conversion date, while others require board approval. Terms of issuance may also allow the repurchase of preference shares by the issuer at specified dates.
To learn more, explore: CLASSES OF SHARE CAPITAL AND ILLUSTRATION OF HOW DIFFERENT TYPES OF SHARES ARE ISSUED.
Determining the Proportions of Preference and Equity Shares
The proportions of preference and equity in a company are determined by calculating the cost of preferred stock, the preferred dividend coverage ratio, and the preferred stock ratio.
The cost of preferred stock (Rp) is the expected return on an investment in preferred stock. It’s calculated using the following formula:
Cost of preferred stock (Rp) = Dividend at 1 yr ÷ (Stock price + Growth rate)
- Cost of Preferred Stock
The cost of preferred stock (Rp) is the expected return on an investment in preferred stock. It’s calculated using the following formula:
Cost of preferred stock (Rp) = Dividend at 1 yr ÷ (Stock price + Growth rate)
A company has preferred stock that has an annual dividend of Rs3 per share. If the current share price is Rs 23 and growth rate is 2%, what is the cost of preferred stock?
dividend = Rs. 3
Stock price = Rs. 23
Growth rate = 2%
Rp = Dividend at 1 yr ÷ Stock price + Growth rate.
Rp = (3 / 25) = 0.12 = 0.12 × 100 = 12%
Preferred Dividend Coverage Ratio (PDPR)
Companies use the cost of preferred stock to compare it with other financing options and to calculate the Weighted Average Cost of Capital (WACC). The PDPR measures a company’s ability to pay its preferred stock dividends. It is calculated using the formula:
PDPR=Required Preferred Dividend Payout÷ Net Income.
Every preferred dividend comes with a percentage rate, so all you need to do is multiply that percentage by the par value to get the Required preferred dividend per share
Companies use the cost of preferred stock to compare it with other financing options and to calculate the Weighted Average Cost of Capital (WACC).
- Preferred Stock Ratio
The preferred stock ratio is determined by dividing the total par value of preferred stock by the company’s total capitalization:
Equity Shares
Equity shares represent partial ownership in a company and provide long-term financing. These shares are traded on stock exchanges and distributed upon the company’s winding up. Reserves and surpluses are part of owners’ equity and are considered in the cost of equity calculations.
Difference between Preference Shares and Equity Shares
- Equity Shares: Provide shareholders the right to vote and share in the company’s profits and assets.
- Preference Shares: Offer preferential rights to dividends and assets but often come with limited or no voting rights.
Equity Ratio
The equity ratio measures the amount of leverage used by a company by comparing total equity to total assets.
The equity ratio is a financial metric that measures the amount of leverage used by a company. It uses investments in assets and the amount of equity.
Equity ratio uses a company’s total assets (current and non-current) and total equity to help indicate how leveraged the company is: how effectively they fund asset requirements without using debt.
The formula is simple: Equity Ratio= Total equity/Total assets
Let’s look at an example to get a better understanding of how the ratio works. For this example, Company’s total assets (current and non-current) are valued Rs.1000000 and its total shareholder (or owner) equity amount is Rs.440000.
Solution:
Total assets = Rs. 1,000,000
Total equity = Rs. 440,000
Using the formula above:
Equity Ratio= 440000/1000000=0.44
So, Equity Ratio: 0.44 or 44%
The resulting ratio above is the sign of a company that has leveraged its debts. It holds 56% debt (560000) which is more than it does equity from shareholders.
A ratio below 50% indicates a leveraged company, while a ratio above 50% indicates conservative financing. Investors prefer companies with a higher equity ratio as they carry lower risk and better creditworthiness.
Lending institutions are more likely to extend credit to companies with higher equity ratios, indicating effective financial management and the ability to repay debts promptly.
