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Cost of Preference Capital

When a company raises money by issuing preference shares, it has to pay a fixed dividend to those shareholders. The Cost of Preference Capital (Kp) is simply the minimum return the company must earn on the funds raised through preference shares so that it can keep paying that dividend without shortchanging its owners.

Here is the most important thing to get right from day one: preference dividend is NOT tax-deductible. Unlike interest on a loan (which reduces taxable income and gives the company a tax shield), preference dividend is paid out of profits after tax. This means you never apply a `(1 - t)` adjustment to preference capital. Students who mix this up with the cost of debt formula lose easy marks.

Now there are two cases you need to master:

1. Irredeemable Preference Shares — shares that are never repaid, just pay dividend forever. Formula: `Kp = D / NP` where D is the annual dividend amount and NP is the Net Proceeds (= Issue Price − Flotation/Underwriting Costs). Simple and direct.

2. Redeemable Preference Shares — shares that will be repaid on a specific future date at the Redemption Value (RV). Here you use the approximation formula that also appears for redeemable debentures:

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

Breaking this down: the numerator adds the annual dividend D to the annual capital gain or loss spread over n years. The denominator is the average of what the company received (NP) and what it will pay back (RV) — this is the average funds employed. This formula is the ICAI's standard approximation method and is almost always what the exam expects.

When preference shares are issued at a premium or discount, the RV and NP will differ — do not ignore this difference. Also, if the question states a dividend rate (say 12% on ₹100 face value), calculate D = 12% × ₹100 = ₹12 per share before plugging in. Always convert rates to absolute rupee amounts first.

This topic is asked frequently as a 4–6 mark numerical question, often embedded inside a Weighted Average Cost of Capital (WACC) problem. Getting Kp right is the foundation for getting WACC right.

📊 Worked example

Example 1 — Irredeemable Preference Shares

Rajesh & Co. Pvt. Ltd. issues 10,000 irredeemable 10% preference shares of ₹100 each at a 5% discount. Flotation costs are ₹2 per share. Calculate Kp.

| Item | Calculation | Amount |

|---|---|---|

| Face Value | Given | ₹100 |

| Issue Price (at 5% discount) | ₹100 × 0.95 | ₹95 |

| Flotation costs | Given | ₹2 |

| Net Proceeds (NP) | ₹95 − ₹2 | ₹93 |

| Annual Dividend (D) | 10% × ₹100 | ₹10 |

`Kp = D / NP = ₹10 / ₹93 = 0.1075 = 10.75%`

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Example 2 — Redeemable Preference Shares

Ms. Iyer's company issues 12% redeemable preference shares of ₹100 each at a premium of ₹5. Flotation costs are ₹3 per share. The shares are redeemable after 8 years at par (₹100). Calculate Kp.

| Item | Calculation | Amount |

|---|---|---|

| Issue Price (at ₹5 premium) | ₹100 + ₹5 | ₹105 |

| Flotation costs | Given | ₹3 |

| Net Proceeds (NP) | ₹105 − ₹3 | ₹102 |

| Redemption Value (RV) | At par | ₹100 |

| Annual Dividend (D) | 12% × ₹100 | ₹12 |

| Years to redemption (n) | Given | 8 |

Apply the approximation formula:

`Numerator = D + (RV − NP)/n = ₹12 + (₹100 − ₹102)/8 = ₹12 − ₹0.25 = ₹11.75`

`Denominator = (RV + NP)/2 = (₹100 + ₹102)/2 = ₹101`

`Kp = ₹11.75 / ₹101 = 0.1163 = 11.63%`

Note: Because the company received more than it will repay (NP > RV), there is a small capital loss to the investor each year, which lowers Kp slightly below the 12% coupon rate.

⚠️ Common exam mistakes

  • Applying the (1 − tax rate) adjustment to preference dividend. Only debt (interest) gets a tax shield. Preference dividend is paid from after-tax profits, so Kp has no tax adjustment at all. Write the formula without `(1 − t)`.
  • Using Face Value instead of Net Proceeds in the denominator. NP = Issue Price − Flotation Costs. Many students just plug in ₹100 face value and lose marks. Always subtract flotation costs.
  • Confusing dividend rate base. Dividend rate is always on face value, not on issue price or market price. If the question says '12% preference share of ₹100 issued at ₹110', D = ₹12, not ₹13.20.
  • Forgetting the capital gain/loss in the redeemable formula. If RV ≠ NP, there is a difference to spread over n years. Students often calculate Kp as just D/NP for redeemable shares — that is the irredeemable formula and will give the wrong answer.
  • Using the wrong denominator in WACC for preference capital. When computing WACC, use the market value of preference shares as the weight, not the book value or face value, unless the question specifically says to use book values.
📖 Reference: Cost of Preference — Institute of Chartered Accountants of India
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