By Michael Brett
Classes of capital and capital issues
So far, when we have talked about the share capital of a company we have talked entirely in terms of ordinary share capital or “equity”. These are the shares whose holders share fully in the risks and rewards from the operations of the business, and the dividend and the share price normally move to reflect the success or failure of the business.
But there are other classes of share capital that the company may have, and by far the most common of these is preference capital. For tax and other reasons it was out of favour for many years and most of the preference shares in company accounts were there for strictly historic reasons. But preference has been making a comeback in recent years.
Preference shares are share capital which has most of the characteristics of debt. They normally pay a fixed dividend, like a fixed rate of interest on a loan. The difference is that the preference dividend is paid out of income that has born corporation tax, whereas loan interest is offsettable against profits for tax purposes.
The precise characteristics of any particular issue of preference shares depend on the constitution of the individual company. But a typical traditional preference share might:
- Pay a fixed dividend on which (as with an ordinary share) basic rate income tax has been paid before it reaches the shareholder.
- Rank before the ordinary shares for dividend payment (the preference dividend must be paid before the company pays any dividend on the ordinary shares–so the preference dividend is far more secure than the ordinary dividend).
- Rank before the ordinary shares in a winding up. Preference shares are typically of £1 nominal value, and if the company has to be liquidated, preference shareholders would normally get their £1 plus arrears of dividend before ordinary shareholders get anything. So preference shares rank after the debt of the company but before the equity capital. In practice, in a winding up there may not be anything left for either the preference or the ordinary shareholders after the company’s debts have been dealt with.
So, from an investor’s point of view, preference shares are more secure than equity but less secure than a loan stock or a bond. And in their basic form they do not share in the increasing prosperity of the company.
However, many variations on the preference them are encountered. You might come across “participating preference shares”. These probably pay a fixed dividend but in addition pay an extra dividend related to the amount paid on the ordinary shares. And convertible preference shares are now common; we will be looking at these later.
But in a property company the most important point is how to allow for preference shares when making a net asset value (NAV) calculation. Take the following breakdown of shareholders’ funds:
Total shareholders’ funds are £10m. But £1m of this represents preference capital, so ordinary shareholders’ funds are only £9m, which is the relevant figure for NAV calculations. Since there are 3m £1 ordinary shares, net assets per share amount to 300p (£9m divided by 3m shares).
A couple of other technicalities relating to shareholders’ funds need dealing with. First is the “scrip issue” or “capitalisation issue”, which often causes confusion in its effects on assets per share.
Suppose we take a company with shareholders’ funds identical to those above, but without the preference capital. There are 3m ordinary shares in issue and the NAV is 300p. And let us suppose the price of the shares in the stock market is 240p. The directors decide that a share capital of £3m is rather small in relation to total shareholders’ funds of £9m. So they decide to use part of the reserves of the company to create new shares, which will be issued free to shareholders pro rata with their existing holdings.
In this example the company decides to use £1m of its revenue reserves to create 1m new £1 ordinary shares. These are distributed to shareholders in the ratio of one new ordinary share for every three they hold. So revenue reserves go down from £2m to £1m and issued ordinary share capital goes up from £3m to £4m. Note that this is purely a book-keeping transaction. No new money is involved. A shareholder who had three shares before has four shares now. But since ordinary shareholders’ funds are still only £9m after knocking off the preference capital, the NAV per share comes back to 225p.
After the scrip issue the breakdown will look like this:
Likewise, the share price adjusts for the scrip issue — assume it was 240p before the issue was announced:
So the market price adjusts down from 240p to 180p, but the total value of the shareholder’s investment remains unchanged.
A rights issue, however, is a very different matter. This is when a company issues new shares for cash, offering them first to existing shareholders. The shares are almost certainly issued below the current market price to encourage shareholders to subscribe. So let us go back to our example of a company with equity capital of £3m, ordinary shareholders’ funds of £9m and a NAV of 300p. The market price of the shares is 240p and 1m new shares are offered at 200p in the ratio of one new share for three held. The issue thus raises £2m. For every new share issued at 200p, 100p represents the nominal value of the share and 100p is the premium at which the share is issued. In accounting terms nominal capital thus increases by £1m and the other £1m raised goes to a form of reserve known as a share premium account. After the issue, shareholders’ funds look like this:
The problem is that the issue of shares at a price below net asset value has diluted the NAV from 300p to 275p, and this is a very different matter from the technical adjustment in the NAV that occurs with a scrip issue. It is one reason why property investment companies are normally very reluctant to raise fresh capital via a rights issue.
