Cost of Preference Share Capital, Factors Influencing, Comparison, Implications

Preference Share Capital refers to funds raised by a company through the issuance of preference shares, a type of equity security. Unlike common shares, preference shares typically provide holders with a fixed dividend, which must be paid before any dividends are distributed to common shareholders. These shares often have no voting rights, but in compensation, they offer a higher claim on assets and earnings. The dividends for preference shares can be cumulative or non-cumulative. If cumulative, unpaid dividends from one year are carried forward to the next year; non-cumulative dividends, on the other hand, do not carry over if not declared. In the event of liquidation, preference shareholders have priority over common shareholders in asset distribution, but they stand behind debt holders. Companies issue preference shares to raise capital without diluting voting rights or incurring debt. Preference shares can be an attractive option for investors seeking a more stable and predictable income than common shares usually offer.

The cost of preference share capital is a critical aspect of corporate finance, reflecting the rate of return a company must offer to attract investors to its preference shares. Understanding this cost is essential for companies in making informed financing decisions and for investors in evaluating the attractiveness of these securities.

• Definition

The cost of preference share capital is the rate of return required by investors in exchange for investing in a company’s preference shares. It’s akin to the interest rate on debt, representing the earnings that preference shareholders expect on their investment. Unlike common shares, which have variable dividends, preference shares typically offer fixed dividends, making their cost more straightforward to calculate.

Calculation

The cost of preference share capital can be calculated using the formula:

Cost of Preference Share Capital (Kp) = Dividend per Preference Share / Net Proceeds per Preference Share​

Where:

• Dividend per Preference Share is the fixed dividend amount paid to preference shareholders.
• Net Proceeds per Preference Share is the amount the company receives per share after deducting issuance costs.

Factors Influencing Cost:

Several factors can influence the cost of preference share capital:

• Market Conditions:

Prevailing interest rates and market conditions significantly affect the cost. In a high-interest-rate environment, investors demand higher returns, increasing the cost.

• Company Risk Profile:

Higher-risk companies typically face a higher cost of capital, as investors demand more significant returns for the increased risk.

• Tax Considerations:

Since preference share dividends are paid from after-tax profits, they don’t provide the tax shield benefits that debt interest payments do, which can influence the overall cost.

• Cumulative vs. Non-Cumulative:

Cumulative preference shares, where missed dividends accumulate and must be paid before any dividends to common shareholders, typically have a lower cost compared to non-cumulative shares due to their lower risk.

• Redemption Policy:

Redeemable preference shares, which can be bought back by the company, may have a different cost profile compared to irredeemable shares, as the redemption feature introduces additional considerations for both the company and investors.

• Participating vs. Non-Participating:

Participating preference shares, which allow shareholders to partake in excess profits, may have a lower cost of capital compared to non-participating shares.

Comparison with Other Sources of Finance:

• Debt:

Debt usually has a lower cost than preference shares, partly due to tax deductibility. However, debt increases financial risk.

• Equity:

Common equity often has a higher cost than preference shares due to the variable nature of dividends and higher risk.

Theoretical Perspectives

• Modigliani-Miller Theorem:

In an ideal world with no taxes, bankruptcy costs, or asymmetric information, the cost of capital is independent of the financing mix. However, in reality, these factors do affect the cost.

• Capital Structure Theories:

Theories like the trade-off theory and pecking order theory provide frameworks for understanding how companies balance different sources of finance, including preference shares.

Practical Considerations

• Investor Preferences:

Different investor groups may be attracted to preference shares for various reasons, such as a preference for fixed income or lower risk relative to common shares.

• Regulatory Requirements:

Regulatory environments can impact the attractiveness and cost of issuing preference shares.

• Market Perceptions:

How the market perceives the issuance of preference shares can influence a company’s overall cost of capital.

Implications for Corporate Finance

• Optimal Capital Structure:

Companies must consider the cost of preference share capital in their quest for an optimal capital structure that minimizes the overall cost of capital and maximizes value.

• Investment Decisions:

The cost of preference share capital can influence investment decisions, as it’s a benchmark for evaluating the expected returns on new projects.

Case Studies and Real-World Examples

Examining how different companies have used preference shares and the associated costs can provide valuable insights. For instance, during periods of financial instability, companies may issue preference shares to strengthen their balance sheets without diluting control, as preference shares typically don’t carry voting rights.