The cost of preference capital represents the effective rate of return a company must offer to its preference shareholders to compensate them for the risk they undertake by investing in the company’s preference shares. It is a crucial component in determining a firm’s overall cost of capital, often referred to as the Weighted Average Cost of Capital (WACC), which is then used as a discount rate in capital budgeting decisions. Unlike common equity, preference shares typically offer a fixed dividend rate and often carry no voting rights, placing them in an intermediate position between debt and common equity in a company’s capital structure in terms of risk and return.

Understanding the cost of preference capital is essential for financial managers to make informed decisions regarding financing mix, capital allocation, and valuation. This cost reflects the market’s required yield on these specific securities, incorporating factors such as the stated dividend rate, the issue price, flotation costs, and the redemption value if the shares are redeemable. A key distinction of preference capital, especially when compared to debt, is the tax treatment of its dividends from the company’s perspective, which profoundly impacts its relative cost.

Understanding Preference Capital

Preference capital, also known as preferred stock or preferred shares, represents a unique type of equity security that possesses characteristics of both debt and common equity. Like debt, preference shares typically pay a fixed dividend, similar to interest payments on bonds, and these dividends usually have preference over common stock dividends. In the event of liquidation, preference shareholders have a claim on the company’s assets that is senior to common stockholders but subordinate to debtholders and other creditors. Unlike common equity, preference shares generally do not confer voting rights, meaning preference shareholders do not participate in the company’s operational decision-making processes.

Companies issue preference shares for a variety of reasons. They provide a means of raising long-term capital without diluting the ownership and control of existing common shareholders. They also offer a more flexible financing option than debt, as preference dividends can be deferred in times of financial distress without triggering bankruptcy (though cumulative preference dividends, if not paid, accumulate and must be paid before common dividends can resume). However, this flexibility comes at a cost, as preference dividends are not tax-deductible for the issuing company, unlike interest payments on debt. This lack of a tax shield significantly influences the effective cost of preference capital compared to debt.

Calculation of Cost of Preference Capital

The calculation of the cost of preference capital (Kp) depends primarily on whether the preference shares are irredeemable (perpetual) or redeemable (finite maturity). The core principle remains the same: it is the discount rate that equates the present value of all future expected cash flows to the net proceeds received by the company from issuing the shares.

Cost of Irredeemable (Perpetual) Preference Shares

Irredeemable preference shares are those that do not have a maturity date, meaning the company is expected to pay dividends indefinitely. Their cost is calculated as the fixed annual dividend divided by the net proceeds from the issue of the shares.

The formula for the cost of irredeemable preference capital is:

Kp = D / NP

Where:

  • Kp = Cost of preference capital
  • D = Annual preference dividend per share. This is calculated as the par value (or face value) of the preference share multiplied by the stated dividend rate. For example, if a preference share has a par value of $100 and a dividend rate of 8%, the annual dividend (D) would be $8.
  • NP = Net proceeds per preference share. This is the issue price per share minus any flotation costs per share. Flotation costs are expenses incurred by the company when issuing new securities, such as underwriting fees, legal fees, accounting fees, printing costs, and registration fees. These costs reduce the actual cash received by the company, effectively increasing the cost of capital.

Example: Suppose a company issues irredeemable preference shares with a par value of $100 and an 8% dividend rate. The shares are issued at par, but flotation costs are $4 per share. D = $100 * 8% = $8 NP = $100 - $4 = $96 Kp = $8 / $96 = 0.0833 or 8.33%

This 8.33% represents the effective annual percentage return that investors demand from these preference shares, considering the initial investment and the perpetual dividend stream. From the company’s perspective, it’s the cost it incurs for every dollar of capital raised through this source.

Cost of Redeemable Preference Shares

Redeemable preference shares have a specified maturity date, at which point the company is obligated to buy back the shares at a predetermined redemption price. The calculation for redeemable preference shares is more complex as it incorporates not only the annual dividends but also the capital gain or loss realized at the time of redemption. This calculation is similar to the yield to maturity (YTM) calculation for bonds, but without the tax deductibility of dividends.

The approximate formula for the cost of redeemable preference capital is:

Kp = [D + (RV - NP) / n] / [(RV + NP) / 2]

Where:

  • Kp = Cost of preference capital
  • D = Annual preference dividend per share.
  • RV = Redemption value per preference share. This is the price at which the company will repurchase the shares at maturity. It can be par value, at a premium, or at a discount.
  • NP = Net proceeds per preference share (issue price per share minus flotation costs per share).
  • n = Number of years to maturity (redemption period).

The numerator represents the average annual cash flow to the investor, comprising the fixed dividend and the annualized capital gain or loss from redemption. The denominator represents the average investment over the life of the preference share.

Example: A company issues redeemable preference shares with a par value of $100, an 8% dividend rate, and a redemption period of 10 years. The shares are issued at par, but flotation costs are $4 per share. The shares will be redeemed at a premium of $5 (i.e., $105).

D = $100 * 8% = $8 RV = $105 NP = $100 - $4 = $96 n = 10 years

Kp = [$8 + ($105 - $96) / 10] / [($105 + $96) / 2] Kp = [$8 + $9 / 10] / [$201 / 2] Kp = [$8 + $0.90] / [$100.50] Kp = $8.90 / $100.50 Kp = 0.08856 or 8.86%

This calculation provides an approximation. For a precise calculation, one would use financial calculator functions or iterative methods (like the internal rate of return concept) to find the discount rate that equates the present value of all future dividends and the redemption value to the net proceeds. However, the above formula is widely used for its practical simplicity and reasonable accuracy.

Factors Affecting the Cost of Preference Capital

Several factors can influence the cost of preference capital, impacting the required dividend rate and the net proceeds from issuance.

  1. Stated Dividend Rate: The most direct factor is the fixed dividend rate announced by the company. A higher stated dividend rate will naturally lead to a higher cost of preference capital, assuming all other factors remain constant. This rate is set to attract investors based on market conditions and the perceived risk of the company.

  2. Issue Price and Par Value: The price at which the preference shares are issued relative to their par value affects the net proceeds. If shares are issued at a premium (above par), the net proceeds are higher, potentially lowering the effective cost. Conversely, issuing at a discount (below par) would increase the effective cost by reducing net proceeds.

  3. Flotation Costs: These are the expenses incurred during the issuance of new securities. Underwriting fees, legal and accounting fees, printing costs, and administrative expenses all reduce the net amount of capital received by the company for each share sold. Higher flotation costs directly reduce the net proceeds (NP), thereby increasing the cost of preference capital (Kp). This is why it’s crucial to use net proceeds, not just the issue price, in the calculation.

  4. Redemption Value (for Redeemable Shares): For redeemable preference shares, the redemption value plays a significant role. If the redemption value (RV) is higher than the net proceeds (NP), it implies a capital gain for the investor, which adds to their return and thus increases the company’s cost. Conversely, if RV is lower than NP, it represents a capital loss, which reduces the investor’s overall return and thereby lowers the company’s effective cost.

  5. Maturity Period (for Redeemable Shares): The length of the redemption period (n) for redeemable preference shares affects how the capital gain or loss is amortized over time. A longer maturity period spreads any capital gain or loss over more years, potentially having a smaller annualized impact on the cost compared to a shorter maturity for the same total capital gain/loss.

  6. Company’s Financial Health and Creditworthiness: A company with strong financial performance, stable earnings, and a low risk of default will be perceived as less risky by investors. This lower risk perception translates to a lower required rate of return, potentially allowing the company to issue preference shares with a lower dividend rate, thus reducing its cost of preference capital. Conversely, a financially struggling company would need to offer a higher dividend rate to attract investors, increasing its cost.

  7. Market Interest Rates and Economic Conditions: The general level of interest rates in the economy influences the attractiveness of fixed-income securities, including preference shares. When market interest rates are high, investors demand a higher return on all fixed-income investments, including preference shares, leading to a higher cost for the issuing company. During periods of low interest rates, the cost tends to be lower. Broad economic conditions, such as inflation expectations and economic growth outlook, also play a role in shaping investor expectations for returns.

  8. Tax Treatment (Crucial Distinction): This is perhaps the most critical factor distinguishing the cost of preference capital from the cost of debt from the company’s perspective. Preference dividends are paid out of a company’s after-tax profits and are not tax-deductible for the issuing company. In contrast, interest payments on debt are tax-deductible, creating a “tax shield” that reduces the effective cost of debt. This lack of a tax shield for preference dividends means that preference capital is generally more expensive than debt, even if the stated dividend rate is lower than the interest rate on comparable debt, because the company cannot reduce its taxable income with preference dividends. While dividends received by investors are subject to personal income tax, this affects the investor’s after-tax return, not the company’s cost directly.

  9. Features of Preference Shares: The specific terms and features embedded in preference shares can also influence their cost:

    • Cumulative vs. Non-cumulative: Cumulative preference shares require that any missed dividends accumulate and must be paid before common shareholders receive any dividends. This reduces investor risk and might slightly lower the required dividend rate (and thus the cost) compared to non-cumulative shares.
    • Participating vs. Non-participating: Participating preference shares allow holders to receive additional dividends beyond the fixed rate under certain conditions (e.g., if common dividends exceed a certain amount). This feature makes them more attractive to investors, potentially allowing for a lower fixed dividend rate.
    • Convertible vs. Non-convertible: Convertible preference shares can be exchanged for a fixed number of common shares. This convertibility feature offers investors an upside potential, which typically makes them more appealing and can reduce the fixed dividend rate required, lowering the cost to the company.
    • Callable vs. Non-callable: Callable preference shares give the issuing company the right to repurchase the shares at a specified price before maturity. This call option is beneficial for the company (e.g., if interest rates fall, they can re-issue shares at a lower cost) but adds risk for investors. To compensate for this risk, callable preference shares might require a slightly higher dividend rate, increasing the cost.

Comparison with Other Sources of Capital

Understanding the cost of preference capital is best done in the context of other financing sources:

  • Debt: Debt is generally the cheapest source of capital for a company primarily due to its tax deductibility. Interest payments reduce a company’s taxable income, creating a significant tax shield. Additionally, debt holders have a senior claim on a company’s assets and earnings, making debt less risky for investors than equity, and thus commanding a lower required rate of return. The cost of debt is often calculated on an after-tax basis: Kd * (1 - Tax Rate). Preference capital lacks this tax shield, making it comparatively more expensive than debt.

  • Common Equity (Retained Earnings and New Equity): Common equity is typically the most expensive source of capital. Common stockholders bear the highest risk as they are residual claimants on the company’s assets and earnings, and their dividends are not fixed. Their required rate of return (Cost of Equity, Ke) is often calculated using models like the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model. Since preference shares offer a fixed dividend and have a senior claim over common stock, they are less risky for investors than common equity, and therefore the cost of preference capital (Kp) is generally lower than the cost of common equity (Ke).

In summary, the cost of capital generally follows this hierarchy: Cost of Debt (after-tax) < Cost of Preference Capital < Cost of Common Equity

This hierarchy reflects the increasing level of risk assumed by investors and the corresponding increasing required rate of return.

Importance of Calculating Cost of Preference Capital

Calculating the cost of preference capital is not merely an academic exercise; it has profound practical implications for a company’s financial management:

  1. Capital Budgeting Decisions: The primary use of the cost of preference capital is in calculating the Weighted Average Cost of Capital (WACC). WACC serves as the discount rate for evaluating potential investment projects. If the expected rate of return from a project is lower than the WACC, it suggests that the project will not generate sufficient returns to satisfy the company’s various capital providers, including preference shareholders, and should therefore be rejected. An accurate Kp ensures that the WACC truly reflects the cost of all financing sources.

  2. Capital Structure Decisions: Understanding the cost of preference capital relative to debt and common equity helps financial managers determine the optimal mix of financing. By analyzing the marginal cost of different capital sources and their impact on the overall WACC, companies can strategize their capital structure to minimize WACC and maximize firm value. While preference shares are more expensive than debt, they offer flexibility (no fixed interest obligation) and do not dilute ownership like common equity, making them suitable for specific financing needs.

  3. Valuation: The cost of preference capital is often used as a discount rate when valuing the preference shares themselves, or as a component of the WACC when valuing the entire firm using methods like the discounted cash flow (DCF) model.

  4. Performance Evaluation: Comparing the actual returns generated by the company’s assets against its WACC (which includes Kp) provides insights into the efficiency of capital deployment. It helps assess whether the company is creating value for its shareholders.

  5. Pricing New Issues: When a company plans to issue new preference shares, an accurate calculation of Kp based on current market conditions and flotation costs is essential for pricing the new issue appropriately to attract investors while managing the company’s cost.

Assumptions and Limitations

While the calculation of the cost of preference capital is straightforward, it relies on several assumptions and has limitations:

  • Constant Dividend: The formulas assume a constant, fixed dividend payment over the life of the preference share. While this is generally true for traditional preference shares, some may have variable dividend rates or participating features that complicate the calculation.
  • Market Efficiency: The calculations implicitly assume that the market price of the preference share reflects all available information and that the required return is what investors truly demand.
  • Fixed Flotation Costs: Flotation costs are assumed to be fixed amounts per share or a fixed percentage. In reality, they can vary.
  • Exclusion of Qualitative Factors: The cost calculation is quantitative and does not directly incorporate qualitative factors such as the company’s reputation, industry outlook, or specific investor preferences, which can indirectly influence the required return.
  • Approximation for Redeemable Shares: The commonly used formula for redeemable preference shares is an approximation. For precise results, an iterative approach or financial calculator is needed.

The cost of preference capital is the effective rate of return that a company must pay to its preference shareholders to compensate them for their investment. It is determined by the annual fixed dividend, the net proceeds received from issuing the shares (after accounting for flotation costs), and, for redeemable shares, the redemption value and the time to maturity. A critical characteristic differentiating preference capital from debt is the non-tax deductibility of preference dividends for the issuing company, which makes preference capital generally more expensive than debt from an after-tax perspective, despite its fixed nature.

Positioned between debt and common equity in terms of risk and return, preference capital provides a valuable financing alternative. Its cost lies above that of tax-advantaged debt but typically below that of riskier common equity. Accurately calculating this cost is indispensable for sound financial management, playing a pivotal role in capital budgeting decisions, optimizing the company’s capital structure, and ultimately contributing to the maximization of shareholder wealth.