Monday, March 22, 2010

(158)---COST OF PREFERENCE SHARE CAPITAL

Cost of Preference Share Capital

Irredeemable Preference Share

The preference share may be treated as a perpetual security if it is irredeemable. Thus, its cost is given by the following equation:

Kp = PDIV/P0

Where Kp is the cost of preference share, PDIV is the expected preference dividend, and P0 is the issue price of preference share.

Redeemable Preference Share

Redeemable preference share (that is preference shares with finite maturity) are also issued in practice. A formula similar to above equation can be used to compute the cost of redeemable preference share:

Kp =(PDIV1 /(1+Kp)1) + (PDIV2 /(1+Kp)2) + ----------- + (PDIVn /(1+Kp)n) + (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 share is automatically computed on an after tax basis. Since interest is tax deductible and preference dividend is not, the after tax cost of preference is substantially higher than the after tax cost of debt.

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