Business Finance · Financial instruments issued or used by companies

Preference Shares: Features, Types and Ranking for IAI Actuarial

Updated 11 October 2026 · Fact-checked

Preference shares are a hybrid security. They pay a fixed dividend that ranks ahead of ordinary dividends, and they rank ahead of ordinary shares (but behind debt) on winding up. Types include cumulative, participating, convertible and redeemable. To solve questions, identify the type, the dividend entitlement, and the ranking.

Understand Preference Shares

A preference share sits between debt and ordinary equity. Like equity, it is a share, so the company is not forced to pay the dividend and non-payment does not put the company into default. Like debt, it usually pays a fixed rate, set as a percentage of the nominal value.

The word "preference" refers to priority. The preference dividend must be paid before any dividend goes to ordinary shareholders. On winding up, preference shareholders are repaid before ordinary shareholders, but only after all creditors, including debenture holders and lenders. Holders normally have no vote, except in set circumstances such as when their dividend is in arrears or their own rights are being changed.

The main types differ in what happens to the dividend and the capital. Cumulative shares carry forward unpaid dividends. Arrears must be cleared before ordinary shareholders get anything. Non-cumulative shares lose a missed dividend. Participating shares get the fixed dividend plus an extra share of profit, often once ordinary dividends reach a set level. Convertible shares can be exchanged for ordinary shares on stated terms. Redeemable shares are repaid on a fixed date or at the option of the company or holder. Irredeemable ones have no repayment date.

Why do companies issue them? They raise capital without diluting control, because there is no vote. They avoid the fixed legal obligation of debt, so there is no default risk if a dividend is skipped. They can add to funds without raising gearing as measured by debt. The cost is that dividends are usually paid from after-tax profit, so there is generally no tax shield as there is on debt interest. Investors want a higher return than on debt because they rank lower.

Compared with debentures: debenture interest is a contractual debt, is tax-deductible, is often secured, and non-payment is default. Preference dividend is paid at the directors' discretion, is not an expense before tax, is unsecured, and ranks lower. Preference shares are less risky than ordinary shares but riskier than debt.

Key rules to remember

Annual preference dividend: Dividend = Rate × Nominal value × Number of shares; Always apply the rate to nominal value, not to the issue price or market price.
Cumulative arrears: Arrears = Σ unpaid dividends for earlier years; Applies only to cumulative shares. Arrears plus the current year dividend must be paid before any ordinary dividend.
Cost of irredeemable preference shares: Kp = D ÷ P0; D is the annual dividend per share and P0 is the current market price (ex-dividend). No tax adjustment is made.
Ranking on winding up: Creditors and debt > Preference shares > Ordinary shares; Preference holders are repaid at nominal value (plus arrears if cumulative and so stated) before ordinary holders receive anything.
Conversion value: Conversion value = Shares received per preference share × Ordinary share price; Compare with the market price of the preference share or its redemption value to judge whether conversion is attractive.

How to solve Preference Shares questions

Use this approach for descriptive and numerical questions on preference shares.

1Identify the type: cumulative or not, participating or not, convertible, redeemable or irredeemable.
2Work out the fixed dividend from the rate and the nominal value, for each year in the question.
3Check profits and ordinary dividend rules. Ask whether the board can pay and whether it chooses to.
4Apply the dividend rules: pay current preference dividend, then arrears if cumulative, then participation if it applies, then ordinary dividends.
5For winding up, list claims in order: secured and unsecured creditors, then preference, then ordinary. Pay from the available funds until they run out.
6For conversion questions, calculate the conversion value and compare it with the redemption value or market price.
7Add the commentary the question asks for: risk and return, control, tax, gearing, and why the company or investor would prefer this instrument.

Quickest way: Rank, rate, carry forward

When to use it: Use this for short MCQs and for quick dividend or liquidation distribution questions.

Write the ranking line: debt, then preference, then ordinary.
Compute annual preference dividend as rate × nominal value.
If cumulative, add all missed years. If not, ignore them.
Pay in order until cash runs out. Whatever is left goes to the next class.
For a compare-with-debenture question, remember five contrasts: legal status, tax treatment, security, ranking and voting.

Common mistakes in Preference Shares

Applying the dividend rate to market price or issue price.
Students link return to the amount invested.
Fix: The stated rate applies to nominal value. Use market price only when calculating the current yield or cost.
Treating a missed preference dividend as a default.
Students confuse preference shares with debentures.
Fix: Dividends are discretionary. Missing one is not a legal default, though a cumulative holder keeps the right to arrears.
Forgetting arrears on cumulative shares.
Students look only at the current year.
Fix: List every year, mark each as paid or unpaid, and total the arrears before paying ordinary shareholders.
Assuming preference dividends are tax-deductible.
Students carry over the treatment of debenture interest.
Fix: Preference dividend is a distribution of after-tax profit, so it does not give the same tax shield as interest.
Placing preference shares above debentures in a winding up.
The word preference suggests top priority.
Fix: Preference means preferred over ordinary shares only. All creditors, including debenture holders, are paid first.
Assuming all preference shares are non-voting and non-participating.
Students memorise the typical case as a rule.
Fix: Read the terms in the question. Participation, convertibility and voting rights depend on the issue terms and the law.

Worked examples

Example 1

A company has 1,00,000 8% cumulative preference shares of ₹100 each and ordinary shares. No preference dividend was paid in Year 1. In Year 2 the board has ₹30,00,000 available to distribute as dividends. How much goes to preference shareholders and how much is left for ordinary shareholders?

Show the solution

Annual preference dividend = 8% × ₹100 × 1,00,000 = ₹8,00,000.
Year 1 was unpaid and the shares are cumulative, so arrears = ₹8,00,000.
Amount due to preference holders in Year 2 = arrears ₹8,00,000 + current ₹8,00,000 = ₹16,00,000.
Remaining for ordinary shareholders = ₹30,00,000 − ₹16,00,000 = ₹14,00,000.

Answer: Preference shareholders receive ₹16,00,000 and ₹14,00,000 is available for ordinary shareholders.

Example 2

A company is wound up. After selling assets, ₹5,00,00,000 is available. Creditors including debenture holders are owed ₹3,80,00,000. Preference shares have a nominal value of ₹1,00,00,000 and ordinary share capital is ₹2,00,00,000. How much do preference and ordinary shareholders receive? Assume preference holders are entitled to repayment of nominal value only.

Show the solution

Pay creditors and debenture holders first: ₹5,00,00,000 − ₹3,80,00,000 = ₹1,20,00,000 remains.
Preference shareholders rank next. They are owed ₹1,00,00,000, which is covered in full.
Remaining after preference = ₹1,20,00,000 − ₹1,00,00,000 = ₹20,00,000.
Ordinary shareholders receive the residual ₹20,00,000, against share capital of ₹2,00,00,000.

Answer: Preference shareholders receive ₹1,00,00,000 and ordinary shareholders receive ₹20,00,000.

Exam tips

In MCQs, the usual trap is ranking. Remember: debt first, preference next, ordinary last.
In written answers, name the type (cumulative, participating, convertible) and then link it to a consequence for dividends or ranking.
When asked why a company issues preference shares, give both sides: benefits such as no dilution of control and no default risk, and costs such as no tax shield and a higher required return than debt.
When comparing with debentures, use a short list: status, tax, security, ranking, voting. This covers marks quickly.
Show the dividend working with units. Examiners give method marks even if the final figure is wrong.

Practice questions from Financial instruments issued or used by companies

Preference Shares in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Preference Shares: frequently asked questions

What is the difference between preference shares and debentures?

Debentures are debt. Interest is a contractual obligation, is tax-deductible and is often secured, and the holder is a creditor. Preference shares are equity-type capital. The dividend is discretionary, is paid from after-tax profit, and holders rank behind creditors.

What is a cumulative preference share?

It is a preference share where any unpaid dividend is carried forward as arrears. The company must clear the arrears and the current dividend before it pays any ordinary dividend. Non-cumulative shares lose the missed dividend.

Why do companies issue preference shares?

They raise funds without giving new holders a vote, so control is not diluted. There is no default if a dividend is missed. They can also suit a company that is near its limit for borrowing. The drawback is that the dividend is not tax-deductible.

What is the difference between participating and convertible preference shares?

Participating shares receive the fixed dividend and also a share in extra profits under the stated terms. Convertible shares can be exchanged for ordinary shares on stated terms. Participation changes the income. Conversion changes the type of security held.