Cost of Preference Capital

Preference shares represent a special type of ownership interest in the firm. They are entitled to a fixed dividend, but subject to availability of profit for distribution. The preference share holders have to be paid their fixed dividends before any distribution of dividends to the equity shareholders. Their dividends are not allowed as an expense for the purpose of taxation. In fact, the preference dividend is a distribution of profits of the business. Because dividends are paid out of profits after taxes, the question of after tax or before tax cost of preference shares does not arise as in case of cost of debentures.

Preference shares can be divided into:
• Irredeemable preference shares
• Redeemable preference shares

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(1) Cost of Irredeemable preference shares

Irredeemable preference shares are those shares issuing by which the company has no obligation to pay back the principal amount of the shares during its lifetime. The only liability of the company is to pay the annual dividends. The cost of irredeemable preference shares is:

Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference stock

Example:  Let us calculate the cost of 10% preference capital of 10,000 preference shares whose face value is \$100. The market price of the share is currently \$115.
Annual dividend = 10% of \$100 = \$10 per share
Kp = \$10/\$115 = 8.7%

Cumulative preference shares:
In case of cumulative preference shares, the market price of the preference stock will be increased by such amount of dividend in arrears. Cumulative preference shares are those shares whose dividends will get accumulated if they are not paid periodically. All the arrears of cumulative preference shares must be paid before paying anything to the equity share holders.

Non-cumulative preference shares:
These are preference shares whose dividends do not get carried forward to the next year if they are not paid during a year.

If the company issues new preference shares, the cost of preference capital would be:

Kp = Annual dividend / Net proceeds after floatation costs, if any.

Example:  A limited company issues 8% preference shares which are irredeemable. The face value of share is \$100 but they are issued at \$105. The floatation cost is \$3 per share.

Kp = \$8/(\$105-\$3) = 7.84%

If the floatation costs are expressed as percentage, the formula will take the following shape:

Kp = Annual dividend/Net proceeds(1-floatation costs)

(2) Cost of Redeemable preference shares

Redeemable preference shares are those shares which have a fixed maturity date at which they would be redeemed.

Cost of Redeemable preference shares = Annual Dividend + (Redeemable Value - Sale value) / Number of years for redemption
(Redeemable Value + Sale value) / 2

Or

Kp = D +(RV - SV) / N
(RV + SV) / 2

Example:  A company issues 10000, 8% preference shares of \$100 each redeemable after 20 years at face value. The floatation costs are \$3 per share.

Redeemable value = \$100;
Sale value = \$100-\$3 = \$97
Annual dividend = \$8 per share.

Kp = 8 + (100 - 97) / 20    = 8.27%
(100 + 97) / 2