Tag: Irredeemable

Preference Share Capital refers to the funds raised by a company through the issue of preference shares. Preference shareholders generally enjoy preferential rights over equity shareholders regarding the payment of dividend and repayment of capital at the time of winding up. The dividend is usually paid at a fixed rate, subject to the terms of issue and applicable law. Preference shares may be cumulative, non cumulative, participating, non participating and redeemable, depending on their features. Preference share capital provides a company with long term finance without normally giving preference shareholders the same voting rights as equity shareholders. Its issue and regulation are governed by the Companies Act, 2013.

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 of Preference Share Capital:

1. Preference Dividend Rate

The preference dividend rate is one of the major factors affecting the cost of preference share capital. Preference shareholders generally receive a fixed rate of dividend on the nominal value of their shares. A higher dividend rate means that the company has to provide a higher return to preference shareholders, resulting in a higher cost of capital. Conversely, a lower dividend rate reduces the cost of preference capital. The dividend rate is determined by factors such as market conditions, company reputation, risk level and investor expectations. Therefore, companies generally try to issue preference shares at a dividend rate that is attractive to investors but economical for the company.

2. Market Interest Rates

Market interest rates have a significant influence on the cost of preference share capital. When prevailing interest rates increase, investors generally expect higher returns from their investments. Consequently, a company may need to offer a higher preference dividend rate to attract investors, increasing the cost of preference capital. When market interest rates decline, companies may be able to issue preference shares at a lower dividend rate. Therefore, financial managers should consider the prevailing and expected interest rate conditions before issuing preference shares. Proper assessment of market rates helps the company raise preference capital at a competitive and reasonable cost.

3. Creditworthiness of the Company

The creditworthiness and financial strength of a company directly influence the cost of preference share capital. A financially strong company with stable earnings and a good reputation is generally considered less risky by investors. Such a company may be able to issue preference shares at a lower dividend rate. On the other hand, a company with weak financial performance or higher financial risk may have to offer a higher return to attract investors. Factors such as profitability, liquidity, debt position and past financial performance influence investor confidence. Better creditworthiness therefore generally results in a lower required cost of preference capital.

4. Risk Associated with Preference Shares

The risk level associated with preference shares influences the return expected by investors and consequently affects the cost of capital. Although preference shareholders generally have preferential rights over equity shareholders regarding dividend and repayment of capital, their investment still carries business and financial risk. If a company has unstable earnings or a high level of debt, investors may demand a higher dividend rate as compensation for increased risk. Higher perceived risk therefore increases the cost of preference capital. Conversely, lower business risk and stable financial performance can help the company raise preference capital at a relatively lower cost.

5. Tax Treatment

The tax treatment of preference dividends is an important consideration in determining the cost of preference share capital. Preference dividends are generally treated as an appropriation of profit rather than an operating expense for income tax purposes. Therefore, unlike interest on qualifying debt, preference dividends generally do not provide a tax shield to the company. As a result, the cost of preference capital is generally considered on a post tax basis without reducing it for the corporate tax rate. Financial managers should consider the applicable tax provisions while comparing preference capital with other sources of finance.

6. Flotation Cost

Flotation cost refers to the expenses incurred while issuing preference shares. These may include underwriting commission, brokerage, legal expenses, registration charges and issue related administrative costs. Such expenses reduce the net proceeds received by the company from the issue. Therefore, the effective cost of preference share capital becomes higher than the stated dividend rate. The higher the flotation expenses, the greater will be the effective cost of raising preference capital. Financial managers should consider these costs while evaluating different financing alternatives. Proper planning of the issue can help reduce unnecessary expenses and ensure that preference capital is raised at an economical cost.

7. Redemption Terms

The redemption terms of preference shares can influence their cost to the company. If preference shares are issued with a specific redemption value or at a premium, the company may have to pay more than the original amount received from investors. This increases the effective cost of preference capital. The redemption period also affects the calculation because the financial manager must consider the timing of the repayment. Preference shares with more demanding redemption conditions may carry a higher effective cost. Therefore, the issue terms, redemption value and maturity period should be carefully considered when determining the overall cost of preference share capital.

Theories of Cost of Preference Share Capital:

1. Dividend Yield Theory

Under the Dividend Yield Theory, the cost of preference share capital is determined by the relationship between the annual preference dividend and the net proceeds received from the issue of preference shares. Since preference shareholders generally receive a fixed dividend, the cost can be calculated using the formula:

Kp = Dp / NP × 100,

where

Kp is the cost of preference capital

Dp is the annual preference dividend

NP is the net proceeds

For example, if a preference share has a face value of ₹100 and carries a 10% dividend, the annual dividend is ₹10. If issued at ₹95, the cost is 10.53%.

2. Cost of Redeemable Preference Share Capital

For Redeemable Preference Shares, the cost of capital considers both the preference dividend and the difference between the redemption value and net issue proceeds. The cost is calculated by considering the annual dividend, redemption premium or discount and the period until redemption.

The approximate formula is:

Kp = [Dp + (RV − NP) / n] / [(RV + NP) / 2] × 100

where

Dp is annual dividend

RV is redemption value

NP is net proceeds

n is the number of years to redemption

This method provides a more accurate measure because it considers the entire financial obligation of the company.

3. Market Value Approach

The Market Value Approach determines the cost of preference share capital using the current market price of preference shares instead of their nominal value. Investors purchase preference shares based on their expected return and prevailing market price.

The basic formula is

Kp = Dp / MP × 100,

where

Dp represents the annual preference dividend

MP represents the market price of the preference share.

For example, if the annual dividend is ₹10 and the market price is ₹90, the cost is 11.11%. This approach reflects the current market expectations and is particularly useful when preference shares are actively traded.

4. Cost Based on Net Proceeds

The Net Proceeds Approach considers the actual amount received by the company after deducting flotation costs such as brokerage, underwriting commission and issue expenses. The cost of preference capital is calculated by dividing the annual preference dividend by the net proceeds.

The formula is Kp = Dp / NP × 100.

For example, if the company receives ₹96 after issue expenses and pays an annual dividend of ₹10, the cost of preference capital is 10.42%. This approach provides a realistic measure because it considers the actual funds available to the company rather than the nominal value of the preference shares.

Example of Cost of Preference Share Capital:

A company issues 10% Preference Shares of ₹100 each at a price of ₹95 per share. The company pays an annual preference dividend of ₹10 per share.

Calculation

Formula:

Cost of Preference Capital (Kp) = Annual Preference Dividend / Net Proceeds × 100

Kp = ₹10 / ₹95 × 100

Kp = 10.53%

If Flotation Cost is ₹5 per share

Net Proceeds:

₹95 − ₹5 = ₹90

Therefore:

Kp = ₹10 / ₹90 × 100

Kp = 11.11%

Conclusion

The cost of preference share capital is 10.53% without considering flotation cost. When flotation cost is considered, the cost increases to 11.11%. This shows that issue expenses increase the effective cost of raising preference capital.