Companies can raise funds by the issue of preference share capital also. The preference share capital is differentiated from equity share capital on account of two basic features namely

i)    The preference share are entitled to receive dividends at fixed rate in priority over the equity shares,
ii)    In case of the liquidation of the company, the preference share holders will get the capital repayment in priority over the distribution among the equity share holders.
It may be noted that there is no obligation o the firm to compulsory pay the preference dividend as the preference dividend is payable only when the sufficient profit are there and the company wants to pay dividends to equity share holders also. The preference dividend is payable as an appropriation of profit unlike interest on debentures which is a charge against profits. Since the payment of the preference dividend is not legally binding on the company, it may be argued that there is no cost of preference share capital to the firm.

No doubt, that the company has no legal obligation to pay preference dividend, but the investors, when they invest the funds in preference share, must have an expectations of getting returns from the company. Therefore, a company should pay dividends to preferences share holders and thus, there is a cost of preference share capital in terms of the fixed rate of dividend. The understanding of cost of capital of preference share capital is conceptually difficult (as there is no legal binding to pay preference dividend) but the calculation does not pose much problem. The fixed rate of dividend on preference share is the starting point for calculation of cost of capital of preference share capital. As the preference shares may either be redeemable or irredeemable, the cost of capital may also be ascertained accordingly.       

REDEEMABLE SHARE

If the preference share are redeemable at the end of a specific period, then the cost of capital of preference share can be calculated by equation.


                                _n
                P  o   =   ∑  PD_i  /  (1+k_p)ⁱ   +   P_n   /   (1 + k_p )ⁿ
                              i =1
Where   P_o  = Net Proceeds on issue of preference shares
             PD   =  Annual preference dividend at fixed rate of dividend
             P_n  =  Amount payable at the time of redemption
             k_p  = Cost of preference share capital, and
             n     =   Redemption period of preference share.



The equation is also to be solved by the trail and error procedure to find out the value of  k  p. The equation, neither the k d  nor PD require any tax adjustment as the preference dividend is payable out of profits after tax and consequently there is no tax shield to the company.   

IRREDEEMABLE SHARE

In case of irredeemable preference share, the dividend at the fixed rate will be payable to the preference share holder perpetually. The cost of capital of the irredeemable preference share can be calculated with the help of equation.



                    k_p =  PD/ P_o

where   PD =  Annual preference dividends
               P_o  =  Net Proceeds on issue of preference shares
               K_p  =  Cost of capital of preference shares.

     
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