COST OF PREFERENCE SHARE CAPITAL - Accounts and Finance for Managers

Cost of Preference Share Capital Formula

The next specific source of cost is cost of preference share capital

  • Cost of preference share capital - From the angle of interest on the amount of debentures it is also like a fixed in charge but not contractual obligation, but the interest payment is contractual in obligation in accordance with the terms and conditions of the issue agreement reached earlier with the company, irrespective of the profits earned.
  • Preference dividend is to be paid only with reference to availability of profits. Normally the Expectations of the preference shareholders are nothing but the preference dividends. The preference shares are classified into two categories viz Redeemable and Irredeemable
  • Let us discuss at first about the Irredeemable preference shares during the issue The first one is the methodology for the computation of the cost of irredeemable preference share

    Kp= Dividend preference share P0 (1–f)


    The second methodology incorporates the dividend taxation which is normally borne by the company during the moment of declaration.

    Kp= Kp=(Dividend prefernce(1+Dt) P0 (1–f)


ABC company issues 11 percent irredeemable preference shares of the face value of Rs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) par value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%

Cost of Preference Share Capital

The next methodology under the preference share capital is the cost computation for redeemable preference share capital. Under this the period of payment of capital is known along with the payment periodical preference dividends.

payment periodical preference dividends

Problem on the preference share capital

  • Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to be redeemed after 10 years. Floatation cost is expected to be 5% Determine the cost of preference shares Kp

Problem on the preference share capital

Problem on the preference share capital

Cost of preference share capital is Kp= 11.9%

The next important cost to be determined is that cost of equity share capital:

  • Equity dividends is not at par with Interest and Preference dividends, these two are subject to fixed in principle. The payment of dividends are subject to the availability of earnings and the future prospects of the firm in the future to grow.
  • Equity shareholders are the last claimants of the company not only in sharing the profits of the company at the end of every year immediately after anything paid to the preference shareholders. It never carries any fixed rate of dividends subject to the availability of profits to disburse.
  • Market value of shares are determined by the Equity dividends which are nothing but the return expect to get.
  • Ke= a minimum rate of return which the firm should earn from the equity portion of financing of the project in order to maintain the value of the share prices.

There are many more models in the computation of cost of equity

  1. Dividend valuation model
  2. Capital Asset Pricing Model
  • Dividend valuation model: The Cost of equity capital Ke is in terms of required rate of return to the tune of future dividends to be paid to the investors.

It is discount rate which equates the present value of future dividends per share with sale proceeds of a share (after adjusting the expenses of flotation of a share)

Po= Dividend of the first year1 Ke – g Ke/ Dividend of the first year1+G Po

&

Problem:

Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25
What would be market price of a share after 1 year and 2 year
Ke= Re.1/25+ 6%= 4%+ 6%= 10%
The market price at the end of 1 year

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P1= Rs.1.06 10%-6% =Rs.26.5

The market price at the end of 2nd year

P2= Rs.1.12 10%-6% =Rs.28

Capital Asset Pricing Model approach: The cost of equity share capital is computed by registering the Beta with reference to the non diversifiable risk in addition to the diversifiable risk of the equity share with reference to market responsiveness.

The basic assumptions of the CAPM approach

  1. The efficiency of the security markets
  2. Investor preferences

The efficiency of the security markets is embedded with the following assumptions:

  • All investors are common expectations about the expected returns, variances and correlation of the expected returns among the various securities in the market
  • All investors have equivalent amount of information
  • All investors are rational
  • No transaction costs
  • No single investor influence the market

The investors' preference with reference to two different types of returns

  1. Highest level return at minimum level risk or
  2. Lowest level of risk for given level of return

The above alternatives are subject to two different type of risk viz Systematic and Unsystematic risk. Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances are given to the investors.
Unsystematic risk which can be reduced to the level of minimum for which no other allowances are given to the investors.
The allowances are given to the investors only subject to the market responsiveness Beta coefficient
Ke= Rf+ b(Km–Rf)

Problem

  • The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM approach. From the information that the risk free rate of return equals 10% ; the firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute the cost of equity capital
    Ke= 10% + 1.5×(12.5%-10%)=13.75%

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