Cost of Preference Shares - FinLib (2024)

The Cost of Preference Shares refers to the minimum rate of return which has to be achieved by investing the money that is received by issuance of Preference Shares. This helps a company to decide if an investment or expenditure decision will generate a sufficient return on the raised capital.

The name might be confusing because the Cost of Preference Shares is not exactly a cost for the company. It is actually a rate of return that is needed to make a profit on the raised capital and it is a component of the overall Cost of Capital for a company. The process of issuing Preference Shares is a type of Equity financing.

The Preference Shares of any company are a special category of equity shares where the rate of dividend is fixed in advance. These dividends are paid in a preferred manner, before any dividend can be distributed to the normal shareholders.

Usually, the Preference Shares do not carry any voting rights. But the holders of the Preference Shares have a higher claim on the assets of the company than the normal shareholders. (Refer: What do investors get on liquidation of a company)

The dividend rate for the normal shareholders is not fixed and the amount distributed to them will depend on the profits generated by the company. Since the normal shareholders are paid last, the issuance of preference shares reduces the profits that are available for the normal shareholders.

This is the main reason why there is a cost associated with the funds obtained by issuance of new shares. Also, the Cost of Equity for issuing normal shares is difficult to calculate because the dividend rate is not fixed and it requires some assumptions.

The holders of Preference Shares are paid after the calculation of the Profit After Tax (PAT) of the company. Since, the tax has already been reduced from the profits that are distributed, there are no tax deductions available when calculating the Cost of Preference Share Capital.

On the other hand, if the company raises capital in the form of debt, then the interest payments on the borrowings are tax deductible. So, the tax rate can be reduced when calculating the Cost of Debt.

Calculating the Cost of Preference Shares is relatively easier because the Dividend Rate is known. So, it is possible to predict the cash flows from the future. The general formula used to calculate it is given below.

\(R_p=\frac{Dividend Per Share}{(Stock Price − Issuance Cost)}×100\)
Where,
\(R_p\): Cost of Preference Shares
\(Stock Price\): The price at which the new shares are issued
\(Issuance Cost\): The per-share fees and charges to issue the new shares

Let us assume that a company raises capital by issuing Preference Shares at a price of INR 160 and an annual dividend of INR 25 is paid. Also, suppose that the company has to pay INR 10 per share as charges to Investment Bankers and other market participants for the entire process. These values can be used in the above formula:

\(R_p=\frac{25}{(160 −10)}×100\)

So, the calculated value of the Cost of Preference Capital in this case, will be ~ 16.67 %.

Usually, the Preference Shares are issued with a pre-defined redemption date in the future. On this date, the company buys back the Preference Shares from the investors, for a price that is fixed at issuance time.

The Cost of Preference Shares in such a scenario will be different because we need to consider and discount the redemption amount. So, the formula in case of Redeemable Preference Shares will be as follows:

\(P(0,T)=(R×Z(0,T))+\sum_{n=1}^{T}{(D_n×Z(0,n))}\)

Where,
\(P(0,T)\): Price of the Preference Share at time 0 and assuming redemption at time ‘\(T\)’
\(R\): Redemption price of the Preference Share at time ‘\(T\)’
\(D_n\): Dividend payments at time ‘\(n\)’

\(Z(0,n)\): Discount Factor, for discounting the cash flow at time ‘\(n\)’ to time 0

The Discount Factor depends on the compounding frequency and if we assume annual compounding, then the Discount Factor in this case will be given by the formula:

\(Z(0,n)=\frac{1}{(1+R_p )^{n}}\)
Where,
\(R_p\): Cost of Preference Shares

The above formula can also be adjusted and used in cases where the cash flows are different for some time periods. For example, suppose that a company promises to pay INR 10 in year 1, INR 15 in year 2, INR 20 in year 3 etc. on their Preference Shares. In such cases, all the future cash flows have to be discounted in the same way that is mentioned in the above formula.

Let us assume that a company raises capital by issuing Redeemable Preference Shares at a price of INR 1,200. Suppose that the company fixes an annual dividend of INR 50 on these shares and promises to buy them back after 3 years at INR 1,500.
So, in this case, the investors will pay INR 1,200 for each share at issuance time. They will receive INR 50 per share for 3 years and at redemption time, they will get back INR 1,500 per share. Let us put this data in the formula.

\(1,200=\frac{50}{(1+R_p )^1} +\frac{50}{(1+R_p )^2} +\frac{50}{(1+R_p )^3} +\frac{1,500}{(1+R_p )^3}\)

After solving the equation, we will get a value of ~ 0.1160, which means that the Cost of Preference Shares in this case is ~ 11.60 %. The Math savvy readers can calculate the above value by using the ‘Solver’ feature in Microsoft Excel. (Refer: How to use Solver in Excel?)