Page 108 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes preference shares if they are issued at (i) face/par value, (ii) 10 per cent premium, and (iii) 5 per
cent discount, (b) compute cost of preference share in these situation assuming 5 per cent dividend.
Solution:

Without dividend tax With dividend tax
(i) Issued at face value (i) Issued at face value
(
14 14 1 + 0.05)
K = =14.6 per cent K = =15.4 per cent
p
p
(100 - 4) 96
(ii) Issued at 10% premium (ii) Issued at 10% premium
(
14 14 1 + 0.05)
K = =13.2 per cent K = =13.9 per cent
p
p
(110 - 4) 106
(iii) Issued at 5% discount (iii) Issued at 5% discount
(
14 14 1 + 0.05)
K = =15.4 per cent K = =16.2 per cent
p
p
(100 - 5 - 3.8) 91.2

Cost of Redeemable Preference Shares
Shares that are issued for a specific maturity period or redeemable after a specific period are
known as redeemable preference shares. The explicit cost of redeemable preference shares is the
discount rate that equates the net proceeds of the sale of preference shares with the present value
of the future dividend and principal repayments. In other words, cost of preference share is the
discount rate that equates the present value of cash inflows (sale proceeds) with the present
value of cash outflows (dividend + principal repayment). Dividends will be paid at the end of
each year, but the principal amount will be repaid either in lump sum at the end of maturity
period or in installments (equal or unequal). If the principal amount is paid in instalments, then
the cash outflow for each year equals to dividend plus part of principal amount. Cost of preference
shares, when the principal amount is repaid in one lump sum amount:

n D t P
NP = å t + n n
t=1 ( 1+K p ) ( 1+K p )

D D D P
NP = 1 1 + 2 2 + 3 3 +..........+ n n
( 1+K p ) ( 1+K p ) ( 1+K p ) ( 1+K p )

Where,
K = Cost of preference share.
p
NP = Net sales proceeds (after discount, flotation cost).
D = Dividend on preference share.

P = Repayment of principal amount at the end of ‘n’ years.
n
Illustration 17: (Lump sum repayment)
A company issues 1,00,000, 10 per cent preference shares of 100 each redeemable after 10 years
at face value. Cost of issue is 10 per cent. Calculate the cost of preference share.
Solution:
n D t P
NP = å t + n n
t=1 ( 1+K p ) ( 1+K p )

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