The procedure for measuring the cost of preference share capital creates some conceptual problems. We have seen from the previous explanations that in case of a debt/borrowing, there is a legal obligation to pay interest at a specified fixed rate while in case of a preference share, there is no such legal obligation.
It may be argued by some others that since the preference dividend is not legally binding on the part of the company (even if such dividends are paid) it cannot be treated as a charge on the earnings. On the contrary, according to them, it is a distribution or appropriation of earnings to a class of owners and as such, preference dividends do not constitute cost.
However, this is not correct. Because, although it is not legally binding on the part of the company to pay preference dividend, the same is paid as and when the company earns sufficient profits. If the preference dividends are not paid it will create a dangerous situation from the standpoint of equity shareholders.
If the preference dividends are not regularly paid, the preference shareholders will enjoy the right to take part in the general meeting with equity shareholders under certain conditions which is not desired by the equity shareholders.
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Moreover, the accumulation of arrear preference dividend may adversely affect the right to equity shareholders. As such, the cost of preference shares should be computed at par with cost of debentures.
The method of computation is shown below:
Illustration:
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A company issues 1,000 10% Preference Shares of Rs 100 each. Calculate the cost of preference shares capital when they are issued at (i) 10% premium, and (ii) at 10% discount.
Solution:
(i) When preference shares are issued at s premium of 10%.
(ii) When preference shares are issued at a discount of 10%.
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