2. COST OF PREFERENCE SHARE
Introduction
In the realm of corporate finance, companies employ various methods to raise
capital to fund their operations, expand their business, and undertake new
projects. One of the avenues used for raising funds is the issuance of preference
shares. Preference shares offer unique benefits to both the issuing company and
the investors. However, like any form of financing, preference shares come with
a cost, which is a crucial consideration for both parties involved. In this
assignment, we will delve into the concept of the cost of preference share,
examining its meaning, components, and significance for companies and
investors alike. Understanding the intricacies of the cost of preference share will
help us appreciate its impact on financial decision-making and capital allocation.
3. Meaning of Cost of Preference Share
cost of preference share refers to the return expected by investors for
investing in a company's preference shares. Preference shares are hybrid
financial instruments that combine characteristics of both equity and debt.
While they provide fixed dividends, they also offer preferential treatment in
terms of asset claims during liquidation compared to common shareholders.
The cost of preference share, therefore, represents the rate of return required
by investors to compensate for the risk associated with holding these shares.
4. Components of Cost of Preference Share
The cost of preference share comprises several components, each
contributing to the overall return expected by investors:
Dividend Rate: The primary component of the cost of preference
share is the fixed dividend rate. Companies issue preference shares
with predetermined dividend rates, which are expressed as a
percentage of the face value of the shares. Investors expect this fixed
income stream as a return on their investment.
Opportunity Cost: Investors consider the opportunity cost when
investing in preference shares. The opportunity cost is the return that
investors could have earned by investing in alternative financial
instruments or opportunities with similar risk profiles. If prevailing
interest rates in the market are high, the opportunity cost of investing
in preference shares may also be high, leading investors to demand a
higher cost for holding these shares.
5. • Preference shares, also known as preferred shares, come in various
types, each offering distinct features and benefits to investors. The
different types of preference shares include:
TYPE OF PREFERENCE SHARES
6. SIGNIFICANCE OF COST OF PREFERENCE SHARE:
THE COST OF PREFERENCE SHARE HOLDS CRITICAL
IMPORTANCE FOR BOTH COMPANIES AND INVESTORS:
For the Issuing Company:
1.Capital Structure Decisions: Understanding the cost of preference share is
essential for companies to make informed decisions about their capital structure.
By considering the cost of various sources of financing, a company can optimize its
capital mix, aiming to minimize the overall cost of capital while meeting its
financial obligations.
2.Financial Planning and Forecasting: The cost of preference share
represents a fixed financial commitment for the company. Accurate forecasting of
this cost helps in planning the company's financials and budgeting effectively for
dividend payments.
7. 3.INVESTOR ATTRACTION: A REASONABLE COST OF
PREFERENCE SHARE IS CRUCIAL FOR ATTRACTING
INVESTORS TO SUBSCRIBE TO THE ISSUANCE. A
COMPETITIVE COST WILL ENHANCE THE COMPANY'S ABILITY
TO RAISE CAPITAL SUCCESSFULL
•For the Investors:
1.Risk Assessment: Investors use the cost of preference share as an
indicator of the risk associated with investing in the company. A higher cost
may imply a higher perceived risk, which investors consider when
evaluating the attractiveness of the investment.
2.Income Stream: Preference shares offer a fixed dividend, making them
appealing to investors seeking a stable income stream. By analyzing the
cost of preference share, investors can assess whether the offered return
aligns with their income requirements.
8. CONCLUSION:
• The cost of preference share is the return expected by investors for
investing in a company's preference shares. It encompasses
components such as the fixed dividend rate, opportunity cost, and
credit risk. Understanding the significance of the cost of preference
share is crucial for companies to make well-informed financing
decisions and for investors to evaluate the risk and potential rewards
of holding preference shares. By carefully analyzing this cost,
companies can optimize their capital structure, and investors can
make informed choices aligned with their financial goals and risk
appetite.
