Preference Shares - Definitions, Formulas, Advantages, Disadvantages & Examples

Preference Capital

The Preference Capital is that portion of capital, which is raised through the issue of the preference shares. This is the hybrid form of financing that has certain characteristics of equity and certain attributes of debentures. The preference share represents a special type of ownership interest in the firm. Preference shareholders must receive their stated dividends prior to the distribution of any earnings to the equity shareholders. In this respect preference shares are very much like bonds or debentures with fixed interest payment. The cost of preference shares can be estimated by dividing the preference dividend per share by the current price per share, as the dividend can be considered a continuous level payment.

Preference Shares

Preference shares are a kind of equity shares that do not have the same voting rights as ordinary equity shares. Unlike ordinary shares, preference shares pay a pre-defined rate of dividend. The dividend is payable after all other payments are made, but before dividend is declared to equity shareholders. Preference shares combine features of equity and debt, they carry equity risk as the principal is not secured and they give out dividend similar to an inter.

Formula:

Dividend (D)

Cost of Preference Share(kp) = ------------------------------------

Market Price – Issue Price (Po)

Advantages of Preference Capital

There is no legal obligation on the firm to pay a dividend to the preference shareholders.
The redemption of preference shares is not distressful for a firm since the shares are redeemed out of the profits and through the issue of fresh shares (preference shares and equity shares).
The preference capital is considered as a component of net worth and hence the creditworthiness of the firm increases.
Preference shareholders do not enjoy the voting rights, and thus, there is no dilution of control.

Disadvantages of Preference Capital

It is very expensive as compared to the debt-capital because unlike debt interest, preference dividend is not tax deductible.
Although, there is no legal obligation to pay the preference dividends, when the payment is made it is done along with the arrears.
The preference shareholder can claim prior to the equity shareholders, in case the dividends are being paid or at the time of winding up of the firm.
If the company does not pay or skips the preference dividend for some time, then the preference shareholders could acquire the voting rights.

Examples:

1. A company is planning to issue 9% preference shares expected to sell at Rs.85 per share. The costs of issuing and selling the shares are expected to be Rs. 3 per share.

Solution:

9% of Rs.85 Rs.7.65

Kp = ------------------------ = ---------------- = 9.33%

Rs.(85 - 3) Rs.82

2. A company raised preference share capital of Rs. 1,00,000 by the issue of 10% preference share of Rs. 10 each. Find out the cost of preference share capital when it is issued at (i) 10% premium, and (ii) 10% discount.

Solution:

Cost of 10% preference share capital

(i) When share of Rs. 10 is issued at 10% premium

Kp = D / P0

= 10 / 11 x 100

= 9.09%

(ii) When share of Rs. 10 is issued at 10% discount

kp = PD / P0

= 10 / 9 x 100

= 11.11%

3. A company has 10% redeemable preference share which are redeemable at 6the end of 10th year from the date of issue. The underwriting expenses are expected to 2%. Find out the effective cost of preference share capital.

Solution:

The cost of preference share (face value = Rs. 100) may be found as follows:

D + (RV – SV) / N

kp = (RV+ SV) / 2

In this case D = 10

RV = 100

SV = 100 – 2 = Rs. 98

10 + (100 – 98) / 10

kp = (100 + 98) / 2

= 10.3%

Note:

The preference capital is similar to the equity in the sense: the preference dividend is paid out of the distributable profits, it is not obligatory on the part of the firm to pay the preference dividend, these dividends are not tax-deductible. The portion of the preference capital resembles the debentures: the rate of dividend is fixed, preference shareholders are given priority over the equity shareholders in case of dividend payment and at the time of winding up of the firm, the preference shareholders do not have the right to vote and the preference capital is repayable. Preference shareholders bear more risk than debt-holders. In case of redeemable preference shares, shareholders get dividends and liquidating value on maturity. If the company does not have profits, preference shareholders may not get any dividends. Unlike interest on debt, preference dividend is not tax deductible. The cost of redeemable preference share. The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid.