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Cost of preference shares

1. Introduction

The cost of preference shares represents the return expected by investors who hold these securities. While it's not a legally binding obligation like debt interest, firms typically prioritize paying preference dividends. Understanding the cost of preference capital is crucial for making informed financial decisions.

2. Key Concepts

  • Cost of Preference Capital (kp): The return expected by preference shareholders, usually expressed as a dividend. It is not tax deductible.
  • Preference Shares: A type of equity that has priority over common shares in terms of dividend payments and asset distribution during liquidation.
  • Irredeemable Preference Shares: Preference shares that have no specific maturity date and pay dividends indefinitely, also known as perpetual preference shares.
  • Redeemable Preference Shares: Preference shares that have a specified maturity date at which the principal amount is repaid to the shareholders.
  • PDIV: Expected preference dividend.
  • P0: Issue price of preference share.

3. Cost of Irredeemable Preference Shares

3.1. Definition

Irredeemable preference shares are treated as perpetual securities, with no fixed maturity date, and they pay dividends indefinitely.

3.2. Formula

The cost of irredeemable preference shares (kp) is calculated as follows:

Kp = PDIV / P0

Where:

  • kp = Cost of preference share
  • PDIV = Expected preference dividend
  • P0 = Issue price of the preference share

3.3. Considerations

  • While dividends are not legally binding, they are often paid by companies with sufficient profits as there is a preference to receiving profits, and also the failure to pay preference dividends may adversely affect the prospects of equity holders.
  • The cost of preference capital is not adjusted for taxes since preference dividends are paid after corporate taxes have been paid and do not represent a tax saving.

3.4. Example 1: Irredeemable Preference Shares

A company issues 10% irredeemable preference shares with a face value of Rs. 100. Calculate the cost of preference capital if:

(i) The issue price is Rs. 95:

Kp = 10 / 95 = 0.1053 or 10.53%

(ii) The issue price is Rs. 105:

Kp = 10 / 105 = 0.0952 or 9.52%

4. Cost of Redeemable Preference Shares

4.1. Definition

Redeemable preference shares have a fixed maturity date, at which the principal is repaid to the shareholders.

4.2. Formula

The cost of redeemable preference shares is calculated by discounting the future dividend payments and principal repayment to their present value, using the following formula:

P0 = ∑ [PDIV / (1 + Kp)^t] + [Pn / (1 + Kp)^n]

Where:

  • P0 = Current price of the preference share.
  • PDIV= Expected preference dividend.
  • Kp= Cost of preference share.
  • n = Number of years to maturity of the preference share.
  • Pn = The principal amount to be paid out on maturity.

In order to use this formula, Kp needs to be solved for iteratively or by trial and error.

4.3. Similarities to Debt

The characteristics of redeemable preference shares are similar to debt instruments as they involve the repayment of principal at a specified maturity date.

4.4. Tax Adjustment

Unlike debt, the cost of preference share is not adjusted for taxes, as dividends are paid from after-tax profits. Thus the cost of preference share is automatically on an after-tax basis. This makes the cost of preference capital higher than the after-tax cost of debt.

5. Key Differences from Debt

6. Conclusion

Understanding the cost of preference shares is essential for capital budgeting and financial management. Unlike debt, the cost of preference shares does not enjoy tax benefits, and although they are generally paid out regularly, they do not have a legal obligation, making their cost different to debt. Different formulas for irredeemable and redeemable preference shares take into consideration their different repayment methods, and the cost of preference share is used to determine the most appropriate sources of financing for an organization.

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