The measurement of cost of preference capital poses some conceptual difficulty. In case of debt, there is binding legal obligation on the firm to pay interest & interest constitutes basis to calculate cost of debt. However, in case of preference capital, payment of dividends is not legally binding on the firm & even if the dividends are paid, it is not a charge on earnings, rather it is a distribution or appropriation of earnings to preference share holders.
Irre Deemable Preference share:-
The preference share may be treated as a perpetual security if it is irredeemable Thus, its cost is given by following equation:-
Kp= Cost of Preference share
PDIV= expected preference dividend
Po= Issue price of preference shares.
Redeemable Preference Share:-
n PDIVt PN
PO = ____ + ________
T=1 (1+Kp)t (1+Kp)n
Cost of Preference share is not adjusted for taxes because preference dividend is paid after corporate taxes have been paid. Preference dividends do not save any taxes. Thus cost of Preference share is automatically computed on an after tax basis. Since interest is tax deductible & preference dividend is not, the after tax cost of preference is substantially higher than after tax cost of debt.
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