Page 296 - DCOM205_ACCOUNTING_FOR_COMPANIES_II

Unit 13: Valuation of Preference Shares

13.1 Valuation of Preference Shares Notes

The two dominant characteristics of a preference share are that it has a preference regarding both
the dividend and capital. Besides these, a preference share may have other benefits also; but they
are not obligatory and depend on the terms of issue and provisions in the Memorandum and
Articles of Association of the company concerned.
Because of the limit placed on the dividend which may be paid on a preference share and the
preferred right for payment of dividend and of capital, the considerations applicable for the
valuation of equity shares are not wholly applicable to the valuation of preference shares.
Consideration should first be given to the rate of capitalisation.

As can be readily seen, the risk involved in investment in preference shares is considerably less
than that in equity shares. It follows, therefore, that the expected rate of return on preference
shares is also lower, with the consequent effect upon the rate of capitalisation.

Did u know? Preference shareholders have preference right over payment of dividend and
settlement of principal amount upon liquidation, over common share holders.
It frequently happens that owing to the attraction of equity investment as a hedge against inflation
as also due to possibility of capital appreciation, a company’s equity share is generally capitalised
at a lower yield on the stock exchange than the same company’s preference share. The theoretical
considerations mentioned earlier for the valuation of equity shares do not generally apply.
The rate of capitalisation will depend not only on the percentage of dividend but also on the other
benefits attached to the preference shares. Some of these additional benefits which a preference
share may carry and their effect on the rate of capitalisation and other aspects of valuation are
stated below:
(a) Preference shares may be cumulative preference shares. In such cases, the risk involved is
still lower, with a corresponding effect on the rate of capitalisation. In cases where there
is uncertainty of future dividends, this is an important right and a preference share not
carrying this right will be valued at a substantially lower figure.
(b) A preference share may be a participating preference share. In this case, it partly partakes
of the characteristics of equity shares and therefore, the rate of capitalisation in respect of
the additional dividend which may be paid will not be the same as for the fixed dividend.
If this additional payment is unrestricted, then the rate of capitalisation in respect thereof
may be taken considerably near to the rate of capitalisation for equity shares, the difference
being due to unequal voting rights.
If there are restrictions on the quantum of such additional dividends, then the rate of
capitalisation will be somewhere between the rate of capitalisation for the fixed dividend
and that for equity shares, depending upon the exact terms of issue. It may also be
mentioned here that the possibility of the payment of additional dividend in future will
be determined for calculating the maintainable future profits and the payment ratio of the
company, and on the terms of payment of such additional dividend. If it is found that the
payment of such additional dividend is not expected to be a regular feature, then it would
be appropriate to take the present worth of such additional dividend as is expected to be
paid in future from time to time.
(c) Because of changes in the company law, only redeemable preference shares can be issued;
if there are non-redeemable ones, they are to be converted into redeemable shares.

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