Cost of Preference Shares
The computation of the cost of preference shares is conceptually difficulties compared to the cost of debt. In the case of debt, as shown above, the interest rate is the basis of calculating cost, as payment of a specific amount of interest is legal commitment on the part of the firm. There is no such obligation in regard to preference dividend. It is true that a fixed stipulated on preference shares. It is also true that holders of such a preferential right a regards payments of dividend as well as return of principal a compared to the ordinary shareholders. But, unlike debt, there is no risk of legal bankruptcy if the firm does not pay the dividends due to the holders of such share. Nevertheless firms can be pay the stipulated dividend, if there are sufficient profiles, for a number of reasons. First the preference of shareholders, already observed, carry a prior right to receive dividend, over the equity shareholders. unless, therefore, the firm pays out the dividend to its preference shareholders it will not be able to pay anything to is ordinary shareholders. Moreover, the preference shares cumulative which means that preference dividend will get accumulated till it is paid. As long as it nothing can be paid to the equity holders. Further, non-payment of preference dividend may be entitle heir holders to participate in the management of the firm is voting rights are conferred on them in more cases. Above all: the firm may encounter difficulty in raising further equity capital mainly because the on-payment for preference dividend adversely affects the prospects of ordinary shareholders. Therefore, the stipulated dividend on preference shares, like the interest on debt, constitutes the basis for the calculation of the cost of preference shares. The cost of preference capital may be defined as the dividend expected by the preference shareholders.
However, unlike interest payments on debt, dividend payable on preference shares is not tax deducible because preference dividend is not a charge on earnings or an item of expenditure it is an appropriation of earnings. In other words, they are paid out of after-tax earnings of the company. Therefore, no adjustment is required for taxes while computing the cost of preference capital.
There are two types of preference shares: (i) irredeemable. and (ii) redeemable. The first category is a kind of perpetual security in that the principal is not to be returned for a long time or is likely to be available till the life of the company. The redeemable preference shares are issued with a maturity date-so that the principal will be repaid at some future date. Accordingly, the cost of preference is calculated sepahtely for these situations.