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. !n 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:
1. !rredeemable preference shares
2. Redeemable preference share

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 = $37
Annual dividend = $8 per share.

Kp = 8 + (100 37) / 20 = 8.27
(100 + 37) / 2

Cost of preference share capital is that part of cost of capital in which we calculate the
amount which is payable to preference shareholders in the form of dividend with fixed rate.
Even, dividend to preference shareholder is on the desire of board of directors
ofcompany and preference shareholder can not pressurize for paying dividend but it doesnt
mean that calculation of cost of pref. share capital is not necessary because, if we dont pay
the dividend to pref. shareholders, it will affect on capability to receive funds from this
source.

Cost oI preI. shure cupitul's Iormolu is given below.

Cost of Pref. Share capital (Kp) = amount of preference dividend/ Preference share
capital

Kp = D/P

If we have obtained this preference share capital after some adjustments like premium or
discount or pay some cost of floatation, at that time, it is our duty to deduct discount
andcost of floatation or add premium in par value of pref. share capital.

In udjostment cuse cost oI preI. shure cupitul will chunge und we cun culcolute it with
Iollowing wuy:-

Kp = D/ NP

D = Annual pref. dividend,

NP = Net proceed = Par value of Pref. share capital - discount - cost of floatation

Or NP = Par value of pref. share capital + Premium

There will no adjustment of tax rates because, dividend on pref. share capital is payable on
net profit after tax adjustment, so need not to do adjustment of tax for comparing it with cost
of debt or cost of equity share capital .

Some, time we issue redeemable preference shares whose amount is payable after some
time.

t the time oI mutority, we need to culcolute cost oI preI. shure cupitul with Iollowing
Iormolu
Cost of redeemable pref. share capital =




D = Annual dividend

MV = Maturity value of pref. shares

NP = Net proceeds of pref. shares

N= number of years

This formula is little different from cost of non redeemable pref. share capital because, we
have to add, the benefit which we have given to pref. share capital at the time of maturity.

Suppose, we have to pay Rs. 10, 00,000 but at the time of issue of pref. share, we had paid
Rs. 2 per issue of pref. share. So, net proceed is Rs. 9,80,000 but if this amount is payable
after 10 years at 10% premium, this will also benefit to pref. share capital and total cost of
pref. share capital will increase. Rate of dividend is 10%.

Cost of pref. share capital

= D + (MV - NP )/n / (MV +NP) X 100

= 100,000 + ( 10,50,000- 9,80,000 )/ ( 10,50,000 + 9,80,000) x 100

= 100,000 + 7,000/ 10, 15,000 X 100

= 10.54%

If we compare it with simple cost of pref. share capital with following way
Kp = D/P X 100 = 100000 / 10, 00,000 X 100 = 10% it is same as dividend rate but Kpr is
more than Kp. So, Kpr will give you correct result.