Redemption of Preference Shares: Meaning and Methods

Redemption of preference shares is when a company buys back its issued preference shares from shareholders at a predetermined date and price. This process not only returns the investment to shareholders but also helps the company restructure its capital, reducing the outstanding shares and often aligning with strategic financial planning.

The term "redeem" generally means to buy back or pay off. In the context of finance, the redemption of preference shares refers to the process where a company buys back its issued preference shares from shareholders. 

Imagine a company, that issued preference shares in 2015 with a promise to buy them back in 2020. As 2020 arrives, the company has grown and accumulated enough funds. It decides to redeem these shares, paying back the shareholders the value of their shares. This move helps the company adjust its financial structure and rewards the shareholders by returning their investment as per the initial agreement. This scenario explains the concept of Redemption of Preference Share Capital. 

Explore: Online Stock Market Courses and Certifications

Table of Content

• Redemption of Shares Meaning
• What is Redemption of Preference Shares?
• Reasons for Preference Shares Redemption
• Provisions of The Companies Act (Section 55)
• Methods of Preference Share Redemption

Redemption of Shares Meaning

Redemption of shares is when a company decides to buy back its shares from shareholders. This can happen at a set time or after a certain period, often at a specific price decided in advance. When a company redeems shares, it reduces the total number of its shares available to the public. This process returns the value of these shares back to the shareholders, and it's often used as a strategy to manage the company's capital structure.

What is Redemption of Preference Shares?

Redemption of preference shares is a process where a company buys back its issued preference shares from shareholders. This usually happens on a predetermined date and often at a pre-agreed price. This process effectively removes preference shares from circulation, and shareholders regain their investment value. Companies use redemption as a financial strategy to adjust their equity structure or to return surplus cash to shareholders, particularly for preference shares with a fixed redemption period.

Reasons for Preference Shares Redemption

Redeeming preference shares involves a company buying back these shares from shareholders, and there are several reasons why a company might choose to do this:

Financial Restructuring: Companies may redeem preference shares to optimize their capital structure. This can include adjusting the debt-to-equity ratio or altering the balance between different types of equity to suit the company's financial strategy better.

Improving Financial Ratios: Redeeming preference shares can improve certain financial ratios, such as earnings per share (EPS), which can make the company more attractive to investors.

Tax Efficiency: Sometimes, redemption is driven by tax considerations. Preference dividends may not be tax-deductible, whereas interest on debt is. Thus, converting preference shares to debt can be more tax-efficient.

Market Signaling: Redeeming preference shares can signal to the market that the company is confident about its cash flows and financial health, potentially boosting investor confidence and the company's stock value.

Cost Reduction: If the dividend rate on preference shares is high, redeeming them can reduce the company’s cost of capital, especially if they can be replaced with cheaper sources of finance.

Contractual Obligations: Some preference shares have a fixed redemption date or condition as part of their issuing terms. Companies must redeem these shares to adhere to these contractual obligations.

Excess Cash Utilization: Companies with excess cash reserves might choose to redeem preference shares, using surplus funds effectively and providing value to shareholders.

Provisions of The Companies Act (Section 55)

The Companies Act 2013 in India, particularly Section 55, lays out specific provisions regarding the issue and redemption of preference shares. Here's a summary of the key points:

Authorization: The issuance of preference shares must be authorized by the company's Articles of Association.

Shareholder Approval: The issue of preference shares requires approval by a special resolution in the shareholders' meeting.

Redemption Period: Preference shares must be redeemed within a period not exceeding 20 years from the date of their issue.

Redemption Source: Preference shares can be redeemed either out of profits of the company that would otherwise be available for dividends, or out of the proceeds of a fresh issue of shares made for redemption.

Creation of Reserve Fund: For the redemption of preference shares, a company is required to create a Capital Redemption Reserve Account, and a sum equivalent to the nominal amount of the shares to be redeemed should be transferred to this account from the profits of the company.

Prohibition on Convertible Preference Shares: The Act prohibits the issue of preference shares which are convertible into equity shares after a certain period.

Dividend Payment: The Act allows for payment of dividends on preference shares according to the terms of their issue, but this is subject to the company's profits and availability of funds.

Failure to Redeem: If a company fails to redeem the preference shares or pay dividends on them, it may lead to penalties, and the concerned directors of the company may also be held liable.

These provisions ensure that the issue and redemption of preference shares are conducted in a manner that is transparent, accountable, and in the best interests of all stakeholders involved.

Methods of Preference Share Redemption

Redemption from Profits: Companies often create a separate fund, known as the Capital Redemption Reserve, by setting aside profits. This reserve is then used to redeem preference shares. It's a prudent method, ensuring the company uses its earnings without depleting its working capital.

Redemption through a Fresh Issue of Shares: A company might issue new shares, either common or preference, to raise funds specifically for redeeming the existing preference shares. This method is like replacing old shares with new ones, maintaining the company’s equity capital while managing its share structure.

Redemption out of Capital: Direct redemption from the company's capital is less common due to legal and regulatory constraints. It's typically a last resort, used when other methods aren't feasible and involves using the company’s financial resources to buy back the preference shares.

Purchase of Own Shares: When the market price is favorable – meaning lower than the redemption value – a company might opt to buy back its shares from the market. This is a cost-effective strategy and can be advantageous in certain market conditions. 

Read more topics related to shares: