Cost of Preference Capital

Cost of preference capital is the sum of amount of dividend paid and expenses incurred for raising preference shares. The dividend paid on preference shares is not deducted from tax, as dividend is an appropriation of profit and not considered as an expense.

Cost of preference share can be calculated by using the following formulae

1. Cost of redeemable preference shares

K_P = [{D + F/N (1 – T) + RP/N}/ {P + NP/2}] * 100

Where,

K_P = Cost of preference share

D = Annual preference dividend

F = Expenses including underwriting commission, brokerage, and discount

N = Number of years to maturity

RP = Redemption premium

P = Redeemable value of preference share

NP = Net proceeds of preference shares

2. Cost of irredeemable preference shares

K_P = (D/NP) * 100

For example, an organization issues 10% preference shares of Rs. 100 each, redeemable at par after 20 years.

Assuming 4% floatation cost and 50% corporate tax; calculate cost of preference share in the following conditions:

1. When preference shares are issued at par
2. When preference shares are issued at 10% discount
3. When preference shares are issued at 10% premium

Solution

The solution is given as follows:

Cost of redeemable preference shares = [{(D + F)/N (1 – T) + RP/N}/ {(P + NP)/2}] * 100

1. When preference shares are issued at par

K_P = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 96)/2}] * 100

= 10.30%

2. When preference shares are issued at 10% discount

K_P = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 86)/2}] * 100

= 10.86%

3. When preference shares are issued at 10% premium

K_P = [{(10 + 4)/20 (1 – 0.50) + 0/20}/ {(100 + 106)/2}] * 100

= 9.80%