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What is the meaning of redemption of preference shares?
Redemption of preference shares refers to a company buying back its issued preference shares from shareholders, either on a fixed date or as per terms set at issuance.
Why do companies redeem preference shares?
Companies redeem preference shares for reasons such as financial restructuring, improving ratios, tax efficiency, market signaling, and meeting contractual obligations.
What are the methods of redeeming preference shares?
Common methods include redemption from profits, through a fresh issue of shares, out of capital, or by purchasing own shares from the market.
What is the role of the Capital Redemption Reserve?
The Capital Redemption Reserve is created by a company from its profits to fund the redemption of preference shares, ensuring it adheres to legal requirements.
Redemption of Preference Shares, Meaning and Methods
Learn about the redemption of preference shares, including methods, legal provisions, and reasons for redemption. Understand how companies manage financial restructuring and optimize capital with this strategy.
Mridula Sharma10 Dec, 2024
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Redemption of Preference Shares
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The term "redeem" refers to the act of buying back or settling a financial obligation. In finance, redeeming preference shares involves a company repurchasing its issued preference shares from its shareholders.
For example, imagine a company that issued preference shares in 2015, promising to buy them back in 2020. By 2020, the company has grown and accumulated sufficient funds. It fulfills its promise by repurchasing the shares, returning the investment to the shareholders. This process not only honors the agreement but also allows the company to streamline its financial structure. This example illustrates the concept of Redemption of Preference Shares.
What Is Redemption of Shares?
Redemption of shares refers to the process where a company repurchases its shares from its shareholders. This typically occurs after a predetermined period or at a specific time, often at an agreed-upon price. By redeeming shares, the company reduces the total number of shares available in the market. This process not only returns the share value to the shareholders but also serves as a strategic move to optimize the company's capital structure.
What is Redemption of Preference Shares?
Redemption of preference shares involves a company repurchasing its issued preference shares from its shareholders. This usually takes place on a specified date and at a pre-determined price. Through this process, the preference shares are removed from circulation, and shareholders receive the value of their investment. Companies often use this strategy to optimize their equity structure or return surplus funds to shareholders, especially for preference shares with a fixed redemption timeline.
Redemption of Preference Shares means a company repurchasing these shares from its shareholders. There are several reasons a company might decide to do this:
Financial Restructuring
: Companies may redeem preference shares to improve their capital structure, such as adjusting the balance between debt and equity to align with their financial goals.
Improving Financial Ratios
: By redeeming preference shares, companies can enhance certain financial ratios, like earnings per share (EPS), making them more appealing to investors.
Tax Efficiency
: In some cases, redemption is driven by tax benefits. While preference dividends are not tax-deductible, interest on debt is. Converting preference shares into debt can therefore offer tax savings.
Market Signaling
: Redeeming preference shares may signal that a company is financially strong and confident in its cash flow, which can improve investor trust and boost stock prices.
Cost Reduction
: If the dividend rate on preference shares is high, redeeming them can lower the company's cost of capital, especially if replaced by cheaper financing options.
Contractual Obligations
: Some preference shares come with fixed redemption dates or conditions. Companies must redeem these shares to meet these contractual requirements.
Utilizing Excess Cash
: Companies with surplus cash reserves may redeem preference shares to make effective use of their funds, providing additional value to shareholders.
Provisions of The Companies Act (Section 55)
The Companies Act 2013, specifically Section 55, outlines the rules for issuing and redemption of preference shares in India. Below is a simplified overview of the key provisions:
Authorization
: Preference shares can only be issued if the company’s Articles of Association permit it.
Shareholder Approval
: Issuing preference shares requires approval through a special resolution at a shareholders' meeting.
Redemption Period
: Preference shares must be redeemed within 20 years from the issue date.
Redemption Source
: The redemption can be funded either from the company’s profits (that would otherwise be paid as dividends) or from the proceeds of a new share issue.
Capital Redemption Reserve
: To redeem preference shares, the company must create a Capital Redemption Reserve and transfer an amount equal to the value of the redeemed shares from the company’s profits into this account.
No Convertible Preference Shares
: The Act prohibits issuing preference shares that can be converted into equity shares after a specified period.
Dividend Payments
: Dividends on preference shares can be paid according to the terms set at issuance, provided the company has sufficient profits and funds available.
Failure to Redeem
: If the company fails to redeem the shares or pay dividends, penalties may apply, and the company’s directors may be held responsible.
These provisions are designed to ensure that the issuance and redemption of preference shares are done transparently, responsibly, and in a way that protects the interests of shareholders and other stakeholders.
Methods of Preference Share Redemption
The following are some methods of Redemption of Preference Shares:
Redemption from Profits
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Companies often set aside profits to create a Capital Redemption Reserve, which is then used to redeem preference shares. This method allows the company to use its earnings without affecting its working capital.
Redemption through a Fresh Issue of Shares
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A company may issue new shares, either common or preference, to raise funds for redeeming the existing preference shares. This method helps maintain the company's equity capital while adjusting its share structure.
Redemption out of Capital
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Although less common due to legal and regulatory limitations, companies may redeem preference shares using their own capital as a last resort when other methods are not feasible.
Purchase of Own Shares
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When market conditions are favorable, such as when the market price is lower than the redemption value, a company may buy back its shares from the market. This can be a cost-effective strategy for redeeming preference shares.
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