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Unlike debt securities, equity securities do not impose an obligation on the issuer to repay the amount financed. Instead, shareholders act as owners of a company with a claim on the company’s net assets and expect that management will act in the shareholders’ best interests. Equities can be split into two main categories: common securities and preference securities.
Common shares signify ownership in a company. Like preferred shareholders, common shareholders have a stake in the company’s net assets during liquidation. However, unlike preferred shareholders, common shareholders engage in the company’s performance and contribute to decision-making through voting rights.
Since it’s not always practical for common shareholders to be present at shareholder meetings, they can appoint someone else to vote on their behalf, which is known as voting by proxy. Statutes typically dictate that each share equals one vote, although cumulative voting is often employed to let smaller shareholders cast multiple votes for a single candidate using each share they hold.
A company can release various common shares with differing voting and ownership rights. For instance, callable common shares allow the company to repurchase them at a specific price, usually when the market price surpasses the strike price. Conversely, putable common shares provide investors with the option to sell them back to the company at a predetermined price, typically when the market price falls below the strike price.
Preference shares take precedence over common shares in receiving dividends and claiming net assets during liquidation. However, preference shares don’t participate in the company’s performance and usually don’t have voting rights.
Unlike debt securities, companies are not required to pay dividends on preference shares, but these dividends are often fixed, similar to interest payments on debt securities. Additionally, they generally offer higher yields than dividends on common shares.
With cumulative preference shares, the accrued preference dividend payments must be paid before any dividends go out to common shareholders. With participating preference shares, shareholders receive an additional dividend if the company’s profits exceed a pre-specified level. Preference shares may also be convertible, meaning they can be converted into common shares at a certain ratio determined at issuance.
Question
What is the most likely reason for an investor to choose a company’s preference shares over its common shares?
- The preference shares offer increased voting rights.
- The preference shares usually have a higher dividend yield than the common shares.
- The preference shares give the investor more exposure to the company’s upside potential.
Solution
The correct answer is B.
The preference shares usually have a higher dividend yield than the common shares to make up for the fact that they don’t offer voting rights.
A is incorrect. Preference shares usually do not have voting rights.
C is incorrect. Since even participating preference shares offer limited upside potential, common shares should offer investors more exposure on the upside.