The measurement of the cost of preference capital poses some conceptual difficulty. In the case of debt, there is a binding legal obligation on the firm to pay interest, and the interest constitutes the basis to calculate the cost of debt. However, in the case of preference capital, payment of dividends is not legally binding on the firm and even if the dividends are paid, it is not a charge on earnings; rather it is a distribution or appropriation of earnings to preference shareholders. One may be, therefore, tempted to conclude that the dividends on preference capital do not constitute cost. This is not true.
The cost of preference capital is a function of the dividend expected by investors. Preference capital is never issued with an intention not to pay dividends. Although it is not legally binding upon the firm to pay dividends on preference capital, yet it is generally paid when the firm makes sufficient profits. The failure to pay dividends, although does not cause bankruptcy, yet it can be a serious matter from the ordinary shareholders’ point of view. The nonpayment of dividends on preference capital may result in voting rights and control to the preference shareholders. More than this, the firm’s credit standing may be damaged. The accumulation of preference dividend arrears may adversely affect the prospects of ordinary shareholders for receiving any dividends, because dividends on preference capital represent a prior claim on profits. As a consequence, the firm may find difficulty in raising funds by issuing preference or equity shares. Also, the market value of the equity shares can be adversely affected if dividends are not paid to the preference shareholders and, therefore, to the equity shareholders. For these reasons, dividends on preference capital should be paid regularly except when the firm does not make profits, or it is in a very tight cash position.
Cost of Irredeemable Preference Shares
The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation:
kp= Pd / Po
- kp is the cost of preference share,
- Pd is the expected preference dividend, and
- Po is the issue price of preference share.
Cost of Redeemable Preference Shares
Redeemable preference shares (that is, preference shares with finite maturity) are also issued in practice. A formula similar to previous equation can be used to compute the cost of redeemable preference share:
P0 = ∑t=1 to n [ Int / (1 +Kp)t ] + [ Pn / (1 + Kp)n ]
The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid. Preference dividends do not save any taxes. Thus, the cost of preference capital is automatically computed on an after-tax basis. Since interest is tax deductible and preference dividend is not, the after-tax cost of preference capital is substantially higher than the after-tax cost of debt.