On Equation Finance Calculator Cost of Preference Shares formula for calculating the Cost of Preference Shares

What is Cost of Preference Shares?

Preference shares are shares of a company that pay out dividends to shareholders before common share dividends are issued. For this reason, they are also known as preferred stock. Preferred stockholders are entitled to be paid from company assets before common stockholder dividends in the event of a company entering bankruptcy or liquidation. Preference shares do not hold voting rights as opposed to common dividends that allow shareholders the right to vote on company decisions if a high enough volume of shares is held by the shareholder.

Cost of Preference Shares Variables

Preference shares generally have a fixed dividend payout while common dividends do not. Assuming that a company will continue to operate indefinitely, preference shares are effectively a form of perpetuity payment and can be valued as such with a Cost of Preference Shares formula.

Rate of Return on Preference Shares (Rp)

The expected rate of return on a preference share is the percentage rate of return after considering both the market value of an individual preference share and its preference dividend payout.

Preference Dividend (D)

The expected dividend payout of a preference share. This is generally an annual payout by preference share issuing companies. As the dividend is generally a set amount and it is assumed that companies will exist indefinitely, the preference dividend is considered an amount that is paid indefinitely or in perpetuity.

Market Value of Preference Share (P0)

The value of the preference shares on the market. This value is the buying and selling price of a preference share.

How to Calculate the Cost of Preference Shares

A company issues a 10% preference share of $500, with a face value of $450. An investor considering these preference shares holds an expected return of 10%, meaning the preference shares must have a return over their 10% expected return in order to consider the investment viable. The value of the preference shares to the investor can be calculated as follows:

Rp = D / P0 = $50 / $450 = 0.1111 = 11.11%

The expected rate of return for these preference shares is 11.11%. As the investor holds an expected return of 10% and the preference shares yield a return of 11.11%, the investor would consider the investment at this time to be lucrative and may undertake purchase of the issued preference shares.

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Advantages of Cost of Preference Shares

Preference shares are advantageous for their fixed dividend payout that is static throughout the life of the issued share by a company. As preference shares are considered higher in priority over common shares, holders of preference shares will receive a dividend before common shareholders and, in the event of bankruptcy, will receive a payout after other debts are paid by a company before common shareholders.

Dividends are only paid out by a dividend-issuing company during periods of profit, in which case preference and common shareholders will forgo dividend payments, however preference share dividends are accumulative and shareholders will receive preference dividends equal to the forgone dividend payout in addition to the expected dividend payout when a company can issue dividends again, before dividends are issued to common shareholders.

A disadvantage to preference shares is their lack of voting rights. While preference shareholders are guaranteed a dividend at a fixed rate for the duration of the company’s existence, they are generally not issued with voting rights, regardless of volume of shares held. Voting rights are generally reserved for common shareholders.

Preference shares can belong to a subcategory of “convertible shares”, where investors can trade their preference shares for a fixed number of common shares. This can be lucrative if the value of common shares begins climbing, allowing investors to reap benefits if the common dividend payout rate greatly exceeds the fixed preference share payout rate.

Cost of Preference Shares Summary

Preference shares are shares that pay dividends at a fixed rate and have priority over common shares. Though they come with no voting rights, preference shares can be converted in some instances into common dividends to reap higher common dividend payouts during economic boom periods of the issuing company. The value of preference shares is dependent on the value of individual shares and the value of the fixed dividend payout. As preference shares can theoretically operate in perpetuity, they are can be valued effectively as perpetuities.

On Equation Finance Calculator App Screen example of Cost of Preference Shares with no values loaded in calculator inputs

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