Cost of Preference Shares

Features and Types of Preference Shares

a. Core Features

• Fixed Dividend: Preference shareholders receive a predetermined dividend rate. This certainty distinguishes them from equity holders, who face variable returns.
• Priority in Dividends: Dividends are paid to preference shareholders before any distribution to equity shareholders.
• Preference in Repayment: During liquidation, their claims are settled before those of ordinary shareholders, but after debt holders.
• Limited Voting Rights: Generally, preference shareholders have no say in company management unless their dividends are in arrears.
• Hybrid Nature: Preference shares blend characteristics of both equity and debt, offering security of returns but limited control.

b. Types: Redeemable vs. Irredeemable

Formula for Cost of Preference Capital

a. Irredeemable Preference Shares

The cost of irredeemable preference shares is calculated using a simple ratio:

Kp = D / NP

• Kp: Cost of preference share capital (expressed as a percentage)
• D: Annual preference dividend per share
• NP: Net proceeds from issue (issue price minus flotation cost)

b. Redeemable Preference Shares

For redeemable preference shares, the formula reflects both annual dividends and the gain/loss on redemption:

Kp = [D + (RV - NP) / n ] / [ (RV + NP) / 2 ]

• Kp: Cost of preference share capital
• D: Annual preference dividend per share
• RV: Redemption value (amount to be paid back on maturity)
• NP: Net proceeds from issue
• n: Number of years to redemption

Dividend, Flotation Cost, and Redemption Value Impact

a. Dividend

• The dividend directly sets the annual cost to the company. A higher dividend increases the cost of capital, making funds more expensive.
• For preference shares, the dividend is typically fixed, so even minor changes in the net proceeds (issue price minus flotation costs) can shift the effective cost.

b. Flotation Cost

• Flotation cost is the expense incurred to issue new preference shares (e.g., underwriting fees, legal costs).
• This cost reduces the net proceeds (NP), raising the cost of capital since the company effectively receives less cash per share issued.

c. Redemption Value

• For redeemable preference shares, the redemption value (RV) is crucial. If shares are issued below their redemption value, the company incurs a capital loss, which increases the cost of preference capital. If issued at a premium, the cost may decrease.
• The adjustment for gain or loss on redemption is spread across the life of the share (i.e., the number of years to maturity).

Example

Let's walk through a typical exam scenario step by step for both types of preference shares.

Irredeemable Preference Shares

Suppose a company issues irredeemable preference shares at ₹100 each, promising a fixed annual dividend of ₹10. There are flotation costs of ₹2 per share. What's the cost of preference capital?

1. Calculate Net Proceeds (NP):
   NP = Issue Price – Flotation Cost = ₹100 – ₹2 = ₹98
2. Apply the formula:
   Kp = D / NP = ₹10 / ₹98 = 0.1020 or 10.20%

Redeemable Preference Shares

A company issues 10,000 preference shares at ₹90 each, with a face value of ₹100, redeemable after 5 years. The fixed dividend is ₹10 per share annually. Flotation costs are ₹2 per share. What is the cost of preference capital?

1. Calculate Net Proceeds (NP):
   NP = ₹90 – ₹2 = ₹88
2. Redemption Value (RV) = ₹100
3. Plug into the formula:
   Kp = [10 + (100 – 88)/5] / [(100 + 88)/2]
4. Calculate numerator:
   10 + (12/5) = 10 + 2.4 = 12.4
5. Calculate denominator:
   (100 + 88)/2 = 188/2 = 94
6. Kp = 12.4 / 94 = 0.1319 or 13.19%

Relationship with Company’s Risk and Payout Policy

a. Risk Profile and Cost of Preference Shares

• The cost of preference shares is generally lower than equity but higher than secured debt, reflecting their intermediate risk. Since dividends are mandatory but not tax-deductible, they represent a definite financial outflow.
• If a company’s risk profile worsens (e.g., unstable earnings), investors may demand a higher dividend rate to compensate, pushing up the cost of new preference capital.

b. Payout Policy

• The company's dividend payout policy determines whether arrears on cumulative preference shares will accrue and need to be cleared before any equity dividend is paid. This feature can influence investor demand and thus the required rate of return (cost of capital).
• Frequent delays or skips in preference dividend payments may force the company to offer new issues at a higher dividend rate, increasing future costs.

Computation and Interpretation: A Mentor’s Perspective

• Always start by identifying the type of preference share. The formula differs for redeemable and irredeemable types.
• Account for all costs associated with the issue—don’t overlook flotation expenses. They may seem small, but their impact on net proceeds, and thus the cost of capital, is significant.
• Interpretation is as important as computation. A higher cost of preference capital means the company is paying more to raise funds, which affects profitability and long-term financial planning.
• In exam scenarios, show all working clearly. Write formulas, substitute values stepwise, and interpret your final answer—this demonstrates clarity and deep understanding.

Remember, preference capital is not a mere funding alternative—it's a tool with nuanced costs and effects. Your grasp of these calculations will not only help in exams but also shape your financial decision-making as a future commerce professional.