Cost of Preference Shares
Preference shares interpret a special type of ownership interest in the firm. They are ennobled to a fixed dividend, but capable to accessibility of profit for distribution. The preference share holders have to be compensated their fixed dividends before any distribution of dividends to the equity shareholders. Their dividends are not permitted as an expense for the aim of taxation. In concept, the preference dividend is a dispersion of profits of the business. Due to dividends are compensated out of profits after taxes, the question of before tax or after tax or cost of preference shares does not come up as in case of cost of debentures.
Preference shares can be carved up into:
Irredeemable preference shares
Redeemable preference shares
a) Cost of Irredeemable preference shares
Irredeemable preference shares are those shares issuing by which the company has no certificate of indebtedness to pay back the principal amount of the shares during its life span. The only financial obligation of the company is to pay the annual dividends. The cost of unreformed preference shares is:
Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference stock
b) Cost of Redeemable preference shares
Redeemable preference shares are those shares which have a constant maturity date at which they would be paid off.
Cost of Redeemable preference shares
= Annual Dividend + (Redeemable Value - Sale value) / Number of years for redemption
(Redeemable Value + Sale value) / 2
Or
Kp = D +(RV - SV) / N
(RV + SV) / 2
Merits of Cost of Preference Shares
1. The preference shares have the virtues of equity shares without their restrictions.
2. Issue of preference shares does not produce any accusation against the assets of the company.
3. The promoters of the company can retain control over the company by issuing preference shares, since the preference shareholders have only limited voting rights.
4. In the case of redeemable preference shares, there is the reward that the amount can be re compensated as soon as the company is in possession of funds flowing out of profits.
5. Preference shares are entitled to a fixed rate of dividend and the company may declare higher rates of dividend for the equity shareholders by dealing on equity and enhance market value.
6. If the company's assets are not of high value, debenture holders will not accept them as collateral securities. from that fact the company prefers to tap market with preference shares.
7. The public repository of companies in excess of the level best limit specified by the Reserve Bank can be knocked off by issuing preference shares.
8. Preference shares are in particular practicable for those investors who want higher rate of return with comparatively lower risk.
9. Preference shares add up to the equity base of the firm and they fortify the financial position of it. Further added equity base raises the ability of the company to borrow in future.
10. Preference shares have diversity and variety, unlike equity shares. Companies thus have flexibility in options.
Drawbacks of Preference Shares
1. In general preference shares carry higher rate of dividend than the rate of interest on debentures.
2. Compared to debt capital, preference share capital is a very expensive source of financing due to the dividend compensated to preference shareholders is not, unlike debt interest, a tax-deductible expense.
3. In the case of accumulative preference shares, debt of dividend collect. It is a permanent load on the profits of the company.
4. Preference shares might be inexpedient as they do not carry voting rights, from the investor's point of view, preference shares may Their interest may be spoiled by equity shareholders in whose hands the control is invested.
5. Preference shares have to magnet. Not even 1% of total corporate capital is raised in this form.
6. Instead of combining the benefits of equity and debt, preference share capital, by chance combines the benefits of equity and debt.
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