The cost of preference share capital is the dividend committed and paid by the company. This cost is not relevant for project evaluation because this is not the cost of obtaining additional capital. To determine the cost of acquiring the marginal cost, we will be finding the yield on the preference share based on the current market value of the preference share.
The preference share is issued at a stated dividend rate on the face value of the share. Although the dividend is not mandatory and it does not create legal obligations like debt, it has the preference of payment over equity for dividend payment and distribution of assets at the time of liquidation. Therefore, without paying the dividend to preference shares, they cannot pay anything to equity shares. In that scenario, management typically tries to pay a regular dividend to the preference shareholders.
Broadly, preference shares can be of two types – Redeemable and Irredeemable.
Cost of Redeemable Preference Shares
These shares are issued for a particular period, and at the expiry of that period, they are redeemed, and the principal is paid back to the preference shareholders. The characteristics are very similar to debt, and therefore the calculations will be similar too. For finding the cost of redeemable preference shares, the following formula can be used.
Here, the preference share is traded at, say P0 with dividend payments’ D’ and principal repayment ‘P.’ The cost of debt is designated by Kp. Kp can be determined by solving the above equation.
Explanation of cost of redeemable preference capital with an example:
For example, a firm had a 9% preference stock that matures after 3 years on the balance sheet. The face value is 1000. Putting the formula when the current market price of the debenture is 950, we get,
Solving the above equation, we will get 11.05%. This is the cost of preference share capital. In the case of debt, it would have required further adjustment with respect to tax because debt enjoys a tax shield. Preference dividend is paid out of profits and not treated as an expense for the company. Instead, it is called profit distribution.
Cost of Irredeemable Preference Shares
These shares are issued for the company’s life and are not redeemed. The cost of irredeemable preference shares can be calculated as follows:
Here, preference share is traded at, say P0 with dividend payments’ D’. Kp designates the cost of debt. Kp can be determined by solving the above equation.
Explanation of cost of irredeemable preference capital with an example:
For example, a firm issued a 10% preference stock of $1000, which has a current market price of $900. Cost can be calculated as below:
Kp = 100/900
Solving the above equation, we will get 11.11%. This is the cost of redeemable preference share capital.
Refer to Cost of Capital to learn more about cost of other sources of capital.