Cost of Preference Share Capital

What is Preference Share Capital?

Preference shares, often called "preferred stock," are a type of equity capital that combines features of both debt and equity. Here’s what makes preference shares unique:

• Fixed Dividend: Preference shareholders receive a fixed dividend before equity shareholders.
• No Voting Rights: Typically, they don’t have voting rights like ordinary shareholders.
• Priority in Liquidation: In case of liquidation, they are paid before equity shareholders but after creditors.

Preference shares are an attractive option for companies that want to raise funds without diluting control (since no voting rights are given).

What is the Cost of Preference Share Capital (Kp)?

The cost of preference share capital (Kp) is the return required by preference shareholders. For the company, it represents the cost of raising funds through preference shares.

Formula for Cost of Preference Share Capital

The formula to calculate the cost of preference shares is:

Where:

• $K_p$ = Cost of preference share capital
• $D$ = Annual fixed dividend
• $P_n$ = Net proceeds from the issue (Market price or issue price minus issuance costs)

Key Characteristics of Cost of Preference Share Capital

1. Fixed Dividend: Unlike equity dividends, which are variable, preference dividends are predetermined and fixed.
2. Non-Tax Deductible: Dividends on preference shares are not tax-deductible for the issuing company (unlike interest on debt).
3. Net Proceeds: Always consider issuance costs (e.g., underwriting fees, legal expenses) while calculating the cost.

Example 1: Basic Calculation

A company issues preference shares with the following details:

• Issue price = ₹100 per share
• Fixed dividend = ₹10 per share
• Issuance cost = ₹5 per share

Let’s calculate $K_p$:

Factors Affecting the Cost of Preference Shares

1. Dividend Rate: Higher fixed dividends increase $K_p$.
2. Market Conditions: If shares are issued at a discount, $P_n$ decreases, increasing $K_p$.
3. Issuance Costs: Higher issuance costs reduce net proceeds, leading to a higher $K_p$.

Types of Preference Shares

1. Cumulative vs. Non-Cumulative:

   • Cumulative: Unpaid dividends accumulate and must be paid later.
   • Non-Cumulative: Unpaid dividends are not carried forward.

2. Redeemable vs. Irredeemable:

   • Redeemable: The company repays the principal after a fixed period.
   • Irredeemable: No repayment; dividends are paid perpetually.

3. Participating vs. Non-Participating:

   • Participating: Shareholders can receive additional dividends beyond the fixed amount.
   • Non-Participating: Only fixed dividends are paid.

Advantages and Disadvantages of Preference Shares

Example 2: Redeemable Preference Shares

When preference shares are redeemable, the cost of capital accounts for the repayment of principal.

• $P_r$ = Redemption price
• $n$ = Number of years to redemption

Example:

A company issues redeemable preference shares:

• Issue price = ₹100 per share
• Fixed dividend = ₹8 per share
• Redemption price = ₹110 per share
• Maturity = 5 years

Solution:

Preference Shares vs. Debt

Exam Tips for UGC NET Aspirants

1. Understand Formula Variations: Know both basic and redeemable formulas.
2. Focus on Characteristics: Non-tax deductibility and fixed dividends are key.
3. Practice Numerical Problems: Questions often include issuance costs and redemption scenarios.

What is Preference Share Capital?

Preference shares, often called "preferred stock," are a type of equity capital that combines features of both debt and equity. Here’s what makes preference shares unique:

• Fixed Dividend: Preference shareholders receive a fixed dividend before equity shareholders.
• No Voting Rights: Typically, they don’t have voting rights like ordinary shareholders.
• Priority in Liquidation: In case of liquidation, they are paid before equity shareholders but after creditors.

Preference shares are an attractive option for companies that want to raise funds without diluting control (since no voting rights are given).

What is the Cost of Preference Share Capital (Kp)?

The cost of preference share capital (Kp) is the return required by preference shareholders. For the company, it represents the cost of raising funds through preference shares.

Formula for Cost of Preference Share Capital

The formula to calculate the cost of preference shares is:

Where:

• $K_p$ = Cost of preference share capital
• $D$ = Annual fixed dividend
• $P_n$ = Net proceeds from the issue (Market price or issue price minus issuance costs)

Key Characteristics of Cost of Preference Share Capital

1. Fixed Dividend: Unlike equity dividends, which are variable, preference dividends are predetermined and fixed.
2. Non-Tax Deductible: Dividends on preference shares are not tax-deductible for the issuing company (unlike interest on debt).
3. Net Proceeds: Always consider issuance costs (e.g., underwriting fees, legal expenses) while calculating the cost.

Example 1: Basic Calculation

A company issues preference shares with the following details:

• Issue price = ₹100 per share
• Fixed dividend = ₹10 per share
• Issuance cost = ₹5 per share

Let’s calculate $K_p$:

Factors Affecting the Cost of Preference Shares

1. Dividend Rate: Higher fixed dividends increase $K_p$.
2. Market Conditions: If shares are issued at a discount, $P_n$ decreases, increasing $K_p$.
3. Issuance Costs: Higher issuance costs reduce net proceeds, leading to a higher $K_p$.

Types of Preference Shares

1. Cumulative vs. Non-Cumulative:

   • Cumulative: Unpaid dividends accumulate and must be paid later.
   • Non-Cumulative: Unpaid dividends are not carried forward.

2. Redeemable vs. Irredeemable:

   • Redeemable: The company repays the principal after a fixed period.
   • Irredeemable: No repayment; dividends are paid perpetually.

3. Participating vs. Non-Participating:

   • Participating: Shareholders can receive additional dividends beyond the fixed amount.
   • Non-Participating: Only fixed dividends are paid.

Advantages and Disadvantages of Preference Shares

Example 2: Redeemable Preference Shares

When preference shares are redeemable, the cost of capital accounts for the repayment of principal.

• $P_r$ = Redemption price
• $n$ = Number of years to redemption

Example:

A company issues redeemable preference shares:

• Issue price = ₹100 per share
• Fixed dividend = ₹8 per share
• Redemption price = ₹110 per share
• Maturity = 5 years

Solution:

Preference Shares vs. Debt

Exam Tips for UGC NET Aspirants

1. Understand Formula Variations: Know both basic and redeemable formulas.
2. Focus on Characteristics: Non-tax deductibility and fixed dividends are key.
3. Practice Numerical Problems: Questions often include issuance costs and redemption scenarios.