Unit 2.

3: Cost of capital and financing decisions

Financial ratios

Lesson 1: Weighted average cost of capital (WACC)

The Importance of the Cost of Capital

Up until this point we have made casual references to the cost of capital
and you should have a sense that this concept is quite important in
management accounting and finance.

Why is the cost of capital important?

Well, the answer to this question is connected back to the principles of

decision-making and relevant costing. There is an opportunity cost of
time which we refer to as the required return. The cost of capital is a
good way to determine this required return.
Why is there an opportunity cost of time?

Allocating funding to a particular decision directly, prevents putting that

funding into a different decision. This is because the amount of funding
available is a limited resource (there is not an unlimited availability of
funds). Therefore, because of this limitation, we have an opportunity
cost of time. If you refer back to our topic on Decision-Making in the
Short Term, whenever we have a limited or constrained resource, we have
an associated opportunity cost. As a result, consistent with relevant
costing principles, a company must ensure that the decisions which it
takes compensate the providers of the funds for their lost ability to invest
elsewhere.

How do we measure this opportunity cost of time?

We measure this opportunity cost through the principle of the required

return which is a measure that includes the value of
both time and risk. We include risk in this measure because not all
decisions have the same risk and so the opportunity cost has to adjust for
the differences in risk between decisions.

We have used the required return, sometimes already in the form of the
weighted average cost of capital (WACC), to:

1. Evaluate long term decisions

When making long term decisions we recognise that the cost of time is
important and that the decision needs to incorporate a measure of the
value of time in the assessment of the decision. We said that a long-term
decision (often taking the form of a capital budgeting project) needs to
incorporate the required return in the analysis to determine a net present
value (NPV) of the decision when we use discounted cash flow
techniques. More often than not we assumed that a fair estimate of the
required return is the cost of capital in the form of the WACC. As a
result, we have seen the cost of capital appear frequently in long term
decisions.

2. Valuing companies

When performing a valuation of a company using discounted cash flows

(in a similar way to a NPV analysis) we also need to consider the value of
time and again we will use the cost of capital as our fair estimate of the
required return when estimating the value of a company using
discounted cash flow techniques. This follows the same principle as
evaluating an individual investment decision within the company. If you
imagine the decision to buy a company as being making one large
investment decision, then you should agree that the value of the company
as a whole is based on how much the company's returns exceed the cost
of capital of the company.

3. Performance evaluation

When measuring the performance of a company, division, or individual,

we often need to compare that performance either directly or indirectly
with some measure of required return. When we look at a company's
return on investment, we would like to compare that to a required
return. When we want to determine a company's residual income, we
need some way of determining the capital charge and therefore we need a
measure of a required return etc. Again, for these situations, we use
the cost of capital as our fair estimate of the required return.

4. Regulated companies and pricing decisions

When a regulator chooses the price of goods or services for a regulated

company, they need to determine a fair price based on ensuring a
sustainable return to the company. This is often done with reference to
a required return for the sources of finance in that company. Think
about how Eskom's prices are regulated by NERSA (the National Energy
Regulator of South Africa). Again, we use the cost of capital as our fair
estimate of the required return.

As a next step, let us look at why it is acceptable to use the cost of capital
as the fair estimate of the required return.

The required return is the minimum that a decision needs to return to

the decision maker in order to compensate for the opportunity cost of
time and the risk of the decision.

The cost of capital is determined by the market and represents the

required return set by the market based on the degree of risk perceived
by the investors.

The cost of capital can be used as the required return if we assume that
markets are efficient and that investors have perfect information. They
will then know the truth of the underlying risks and will assess the
required return appropriately.
Investing vs Financing decision

A company uses many sources of finance

Determining the cost of capital for a company would be a relatively simple

process if a company had a single source of funds, say equity.

A company may obtain funds from a number of different sources

- Debt
- Equity, and
- Preference shares

Core principle – pooling of funds theory

- The decision to invest must be made separately to the decision to

finance
- Each new investment cannot be financed in the ptoportions of the
capital structure
o Could use only retained earnings (equity) or
o Could use only new debt or
o Could use a mix of debt and equity
- Normally it is a stepwise process of alternating between sources
- Using project specific finance options is inconsistent decisions
o The fact that the company is using a certain source of funds is
a result of circumstances and not the project itself
- The investing and financing decision are normally separate
Pooling of funds

A Ltd has the following investment project coming available

- A Ltd has a weighted average cost of capital (WACC) of 11%

First: Project 1 expects to earn 10% and be financed with Debt at 8%

Later: Project 2 expects to earn 12% and be financed with equity

Decision using project specific finance

- Accept project A with ER of 10% and project B with ER of 12%

Decision using pooling of funds theory (WACC)

- Reject project A with ER of 10% and accept Project B with ER of 12%

So, to summarise what we have learnt in this first lesson on the cost of
capital:

 We know why the cost of capital is important as we use it to

represent the required return when evaluating decisions, valuing
companies, and assessing performance.

 We know that there is a difference between the required return and

the cost of capital and that in some circumstances it is not
appropriate to just assume they are one and the same.

 We know that we must not mix investing and financing decisions as

it will result in incorrect decision making.
Lesson 1c : WACC
using a WACC results in the correct cost of finance provided that

- Use marginal costs

o We need to determine what the finance would cost today and
not what it happened to cost before
- Include the effect of company tax on debt
o The interest deduction is available as a result of the use of
debt finance and not because of the decision to invest
o This tax ‘saving’ reduces the true cost of debt finance –
interest tax shield
- Use nominal rates (including inflation)
o This goes back to what the investment cash flows are
forecasted in, but generally these are nominal cash flows
- Use target capital structure weightings
o Market values can be used on the assumption that they
represent target weightings
 Actual MV capital structure does not equal target capital
structure

Calculating WACC

Sources of finance in capital structure

- Normal shares (equity)

- Preference shares (equity/liability)
 - Debt instruments (liability)
o Bonds/debentures
o Bank loans

Only permanent/long term sources part of capital structure

- Current liabilities excluded

o Considered part of operations/investment decision
o Careful of short term debt used on a permanent basis – bank
overdraft
- Value of normal share represents all equity
o Share capital/share premium
o Retained earnings
o Revaluation reserves
o Excluding preference share capital/preference share premium

Weightings in capital structure

Various options to weight

- Target weightings
o Long term weightings the company plans to achieve
o May differ in current weightings
o 1st prize – consistent with long term decision making
- Market values
o Weightings determined by current market or fair values
o Not always easy to determine – require valuation
o 2nd prize
- Book values
o Weightings determined as measured in financial statements
o Book value not equal to market value
o 3rd prize – does not consider market values or long term

Calculate WACC

Assume

- 3 sources of finance identified

o Equity, preference shares and debt
- Cost of components given
- Weightings of components given – remember priority
1. Target
2. Market values
3. Book values
Lesson 2: The cost of debt (kd)

What is considered debt?

We use many different names and terminologies to describe the different

types of finance:

 Ordinary shares,

 Redeemable preference shares,

 Zero coupon bonds,

 Debentures,

 etc.

Ultimately, all sources of finance, from debt to equity, are really just
contracts between the company and the party providing the
finance. These contracts will state the obligations that each party has to
one another. A share certificate provides for rights and obligations in
the same way that a loan agreement provides rights and obligations to
the parties involved.

Companies can create contracts with other parties that have terms and
conditions that are as unique as they wish. Understanding how these
contracts are structured is key to determining how the source of finance is
best classified.

As a result, there are many different types of contracts that can be

classified into the category 'debt' for the purposes of understanding a
company's capital structure.

Typically, debt finance has the following characteristics:

 Debt typically has defined interest payments that must be paid by

the company (even variable debt defines how the cash flows will be
determined);

 Debt typically has defined capital repayments (either over the

period or at maturity) which must be repaid by the company;
  Debt has a preferential claim to interest payments and payments on
liquidation;

 Debt holders usually do not have voting rights or an ability to

control the company;

 Debt is usually tax deductible;

Debt classified as part of the Capital Structure

One important distinction is the how to classify the liabilities which are
found on the balance sheet into:

 Debt that forms part of the capital structure, and

 Liabilities that form part of operations.

We touched on this issue in the previous lesson, but it is worth recapping

again here. Remember:

Debt classified as part of the capital structure

Capital structure debt is used to fund assets in the business in general and
usually on a long-term basis. This is aligned with long term decision-
making and the separation of the investing and the financing decision.
We look at the nature of the debt and not how it happens to be classified
using accounting principles.

For example: The portion of a loan that is coming due in the next 12
months is classified as a current liability under financial accounting.
However, from a finance perspective the nature of that current portion is
that it is simply the amount coming due of a long-term debt.

For example: The bank overdraft that is used on a permanent basis, i.e.,
never really repaid and remains outstanding on a long-term basis is really
just a long-term source of finance despite financial accounting classifying
it as current on the statement of financial position.

For example: Trade payables are used to fund specific assets, usually
inventory, and although they are a form of funding, the funding is not
available to buy any assets the company wishes. As a result, this decision
is connected to the investment decision (operations) and not the financing
decision (capital structure).
Cost of debt – (kd)

Typically 3 broad types

- Variable rate vs fixed rate

- Redeemable vs non-redeemable
- General principle = cost of debt is the IRR of the instrument

Variable rate

e.g., bank loans

- Redeemable and non-redeemable

o Interest rate (i) = current market rate
 Rate changes the IRR = current market rate

Fixed rate

e.g., bank loans

e.g., debentures/bonds paying a coupon

- Redeemable
o Interest rate (i) does not equal coupon rate
 The coupon is a cash flow not an interest rate
o Interest rate (i) = YTM = IRR = market rate = effective rate
o i.e., lay out cash flows and determine IRR
- non-redeemable
o interest rate (i) = interest payment (coupon)/market value

Cost of debt – (dk) and tax

SARS tax deductions

- generally interest is tax deductible

- s11(a) in production of income
o relates to an amount actually incurred not effective interest
rate
- s24J deduction based on effective interest rate
o This simply results in I x (1 – t)

Example

Calculating IRR of a bond/debenture

- Current bond price R93.80

- Face value R100 coupon rate 10% p.a
- Redeemed in 5 years time
- Assume tax = 28% not 29%
Example 1

Calculate the cost of variable rate debt

- Company A has a bank loan with an interest rate of 2% above prime

- When the loan was taken out 1 year ago the prime rate was 9%
- Currently the prime rate is 10%
- The amount owed on the bank loan is R1 000 000
- When the loan was taken out it was for R1 500 000
- The tax rate is 30%

Answer

8.4%

Workings

10% current prime rate + 2% credit spread = 12% before tax cost of debt

12% x (1- 30%) = 8.4% after tax cost of debt

Example 2

Calculating the cost of non-redeemable fixed rate debt

 Company A has a non-redeeming loan with an interest rate of 2%

above prime.

 When the loan was taken out 1 year ago the prime rate was 9%.

 Currently the prime rate is 10%.

 Currently the spread above prime for Company A is 3%.

 When the loan was taken out it was for R1 500 000.

 The current market value of the loan is R1 200 000.

 The tax rate is 30%.

What is the cost of debt for use in determining a Company A's cost of
capital?

Answer

+/- 9.6%

Workings

Interest is fixed therefore original interest applies - 2% + 9% = 11%

current interest rate.

Interest payment is therefore 11% x 1 500 000 = 165 000 per year.

Current loan value is R1 200 000 and so current the yield is 165 000 / 1
200 000 = 13.75% before tax.

13.75% x (1 - 30%) = 9.6% after tax cost of debt.

Example 3

Calculating the cost of redeemable fixed rate debt

 Company A has 1 000 redeemable debentures with a face value R2

000 each.

 The debentures were issued 2 years ago with a coupon rate of 11%
and at a discount to face value of 20%.

 The debentures will be redeemed at a 10% discount to the face

value in 5 years’ from today.

 The debentures are currently worth R1 700 each.

 The tax rate is 30%.

What is the cost of debt for use in determining a Company A's cost of
capital?

Answer

+/- 9.7%

Workings

The easiest way to do this is to lay out the cash flows and calculate the
IRR.
Calculating the cost of debt for use in determining cost of capital

0 1 2 3 4 5

Capital 1 700 (1 800)

Coupon (220) (220) (220) (220) (220)

Net cash
1 700 (220) (220) (220) (220) (2 020)
flow

IRR 13.83%

Because the above cash flows ignore tax the IRR is a before tax number.

IRR = 13.83% before tax.

13.83% x (1 - 30%) = 9.68% after tax cost of debt.

Cost of preference share – (kp)

Can take a number of forms

- Redeemable and non-redeemable

Receive a preference dividend

- Technically not a fixed obligation – but strong expectation

o Cant pay ordinary dividend until preference dividend paid
o If in arrears preference shareholders given voting rights
o Failure to pay will damage credit worthiness of company
- No tax effect as payment is a dividend and it not deductible
- General principle = cost of preference is the IRR of the instrument

Redeemable

- Cost of preference (kp) does not equal dividend rate

o The dividend is a cash flow not an effective rate
- Cost of preference (kp) = YTM =IRR = market rate = effective rate
- i.e., lay out cash flows and determine IRR

Non-redeemable

- Cost of preference (kp) = dividend/market value

Example

Preference share cost

- Non redeemable
- Issue price of 100 cents per share
- Current value 85.71 cents per share
- Dividend rate of 12%
Example 1

Calculating the cost of non-redeemable preference shares

 Company A has 2.5 million preference shares in issue with a nominal

value of R80 each.

 The preference shares pay a dividend of 15% per year.

 The current fair value of the preference shares are R70 each.

 The tax rate is 30%.

What is the cost of the preference shares for use in determining a

Company A's cost of capital?

Answer

17.14%

Workings

The dividend is fixed and therefore the original dividend rate applies =
15% dividend rate.

Dividend is therefore 15% x R80 nominal value = R12 dividend per year.

Current preference share value is R70 and so current yield is 12 / 70 =

17.14% before tax.

Dividend is not tax deductible and so 17.14% is also the after-tax rate.
Example 2

Calculating the cost of redeemable preference shares

 Company A has 2.5 million preference shares in issue with a nominal

value of R80 each.

 The preference shares pay a dividend of 15% per year.

 The current fair value of the preference shares are R85 each.

 The preference shares are redeemable at R90 in 5 years’ time.

 The tax rate is 30%.

What is the cost of the preference shares for use in determining a

Company A's cost of capital?

Answer

14.99%

Workings

The dividend is fixed and therefore the original dividend rate applies =
15% dividend rate.

Dividend is therefore 15% x R80 nominal value = R12 dividend per year.

It is easier to simply place these cash flows on a forecast and determine

the IRR

Calculating the cost of redeemable preference shares

0 1 2 3 4 5

Capital 85 (90)

Coupon (12) (12) (12) (12) (12)

Net cash
85 (12) (12) (12) (12) (102)
flow

14.99
IRR
%
Dividend is not tax deductible and so 14.99% is also the after tax rate.

Lesson 4: The cost of equity (ke)

In the previous two lessons we learnt how to calculate the cost of

debt and preference shares for the purposes of determining a weighted
average cost of capital (WACC). Both these categories of sources of
capital follow largely the same principles.

Step 1 - determine the before tax cash flows as if you were buying them.

Step 2 - determine the IRR

Step 3 - remove the tax effect if relevant to that particular category.

In this lesson we move to estimating the cost of equity. The key issue to
realise is that because equity does not have any defined cash flows,
estimating its cost becomes very subjective and ultimately professional
judgement is key.

For this course we are going to focus on the following theoretical ways of
estimating the cost of equity:

 Dividend growth model (DGM);

 Capital asset pricing model (CAPM);

 Relative cost of equity; and

 Bond yield plus a premium.

Dividend growth model

- Value = PV of future dividends

- Rework to determine the expected return
Example

- Current price: R7.68

- Expected EPS for the next year: R1.28
- Dividend payout ratio: 30%
- Expected growth rate: 11% p.a.

Capital asset pricing model

Small company risk premium? Sometimes add 2 – 5% as an adjustment

Example

Relative cost of equity

Expected return is relative to a similar company

Business risks
 - Growth
o If growth prospects are higher than listed company – less risk
- Asset base
o If assets have not been maintained/regularly replaced –
earnings may not be maintainable – more risk
- Management
o Are there equivalent managers to the listed company? – if not
– more risk
- Comparative performance
o Is the unlisted company performing as well? If not – more risk
- Other
o Size of the company
o Standing in industry
o Reliability of financial estimates
o Geographic location of company
o Labour relationships within company

Financial risks
Bond yield plus a risk premium

Expected return is relative to bon instruments

- Use bond yield as a starting point

o Actual bond of company or similar company
o Or bank borrowing costs
o Ideally not risk free rate
 The rate will include company specific risk
o Add a risk premium
 Mostly range from 2% to 6%
 Subjective and depends on judgement
Optimal capital structure
Sources of finance
Capital structure

- Relationship between debt and equity = capital structure

- Always a trade-off between risk and return.
- Use of debt increases risk and return.

Return effects

- Cost
o Debt holders take less risk then equity holders - cost of debt is
usually lower than equity
o Cost of issuing debt is less than issuing equity
- Financial leverage
o A company with no debt - Shareholders return = return on
assets
o Interest payment must be made irrespective of the
performance of the company
o Advantage if company is doing well and earning more than the
interest charge
 Shareholders returns are levered higher than the return
on assets
o Disadvantage if company is doing badly
 Shareholders returns are levered lower than the return
on assets
 Could put the company insolvent
- Tax deductibility
o Interest charge is usually tax deductible - effective cost is
therefore after tax
o Dividends are not tax deductible

Risk effects

- Commitment
o Interest payments on debt must be met whether there are
profits or not
- Capital Repayment
o Ultimately all debt must be repaid
o Companies must provide for repayment
 Issuing / borrowing new debt (rolling)
 Ensuring sufficient cash is available to repay
 - Flexibility
o Limited amount of debt can be raised before the market re-
evaluates the firm’s risk profile
 Equity holders demand higher return
 Debt holders stop lending / lend at higher rates
o Using debt reduces the firm’s flexibility for raising future debt
finance
 When urgently needed for an opportunity
 When interest rates drop
- Signalling effects
o Share issue – perceived that share overvalued
o Debt issue – may have opposite effect

Control

- Dilution of Control
o Issuing shares dilutes ownership control
o Issuing debt may mean restrictive covenants are imposed as a
condition of the loan
 Limit ability to pay dividends
 Limit disposal of assets
 Limit raising additional borrowings
 Maintain specified working capital ratios
- Levels / degrees of control with value
o 75% of issued share capital – enables passing of special
resolutions
o 50% of issued share capital – enables the passing of ordinary
resolutions
o 20% or 30% of issued share capital = enough to effectively
control a listed
company
o 35% is effective control in terms of the Takeover Code – must
make offer
to all shareholders
o Control of the board
 Having the ability to elect directors
o Effect of default
 Arrear preference dividend imparts voting rights
 Loan contract could do similar
Lesson 2
Lesson 6: Sources of finance
Equity instruments

Ordinary shares

Ordinary shares are a financial instrument that are issued to the owners of
a company and are usually the primary source of a company's capital.

The share instrument is represented by a share certificate that

is produced and issued by the company certifying the owner as having
shares in the company. The share certificates should tie back to the share
register where a record of all the shares are kept and managed. A listed
company dematerialises Links to an external site.its share certificates
turning them into digital shares for use on the stock exchange.

The share certificate represents a claim to the residual value of the

company and a right to vote and control the company. A shareholder
receives returns through capital gains when selling or dividends when
declared.

It is important to remember that the book entries representing the shares

on the balance sheet are more than just the issued share capital. In
reality, because the shares have a claim on all residual value the share
certificates are represented by a number of book entries:

 Share capital

 Share premium (if any)

 Retained earnings

 Non distributable reserves

 etc...

Take a look at this article from investopedia where there is a brief

explanation on ordinary shares.Links to an external site.

Ordinary shares as a source of finance:

There are a few ways that a company can obtain finance through ordinary
shares, either directly from shareholders when shares are issued or
indirectly through profit made as explained below.

Retained earnings

This source is, by definition, available should the company decide not to
declare dividends. Any earnings retained add to the claim that a share
has on the company as it represents value not paid to the shareholder and
used as a source of finance. The act of not declaring a dividend is the
process of increasing this source of equity finance. The act of declaring a
dividend reduces retained earnings and therefore the value of equity as a
source of finance.

Issuing more shares

A company can choose to issue new shares to new shareholders or the

market in general. This would bring in additional cash and increase the
share capital and increase the use of equity as a source of finance. A
company can also buy back its own shares using up cash and reducing the
use of equity as a source of finance. Issuing shares has costs associated
with the share issue which can make the process expensive.

Rights issue

A company can choose to offer existing shareholders the right to take up

more shares in the company at a particular value. A rights issue is
different to simply issuing new shares as its designed to protect
shareholders from voting dilution (assuming they follow their rights)
whereas a general share issue does not directly do this. Often the right is
to buy more shares at a discount to the current value to encourage
shareholders to take up the rights offer.

This article and example explains rights offers quite well.Links to an

external site.

✏️ Note: You need to understand the financial impact on value and control
as a result of a rights issue.

In the next part of this lesson, we move onto debt instruments.

Debt Instruments

What is debt?

Debt is money borrowed by one party from another party. A debt contract
gives the borrower the money on condition that it is paid back at a later
date with interest.

Important general characteristics of debt

 Interest rate

o Fixed interest - fixed rate of interest for the term of the issue.
e.g., bonds (debenturesLinks to an external site.)
 o Variable rate – fluctuates according to market forces and
based on a reference rate. E.g., mortgage bonds

 Security on debt

o To protect the lender debt often is connected to some form of

security. Security can take the form of specific assets - e.g., a
car loan or a home loan or people's personal estate (if a
person signs personal surety for a company's debt).

o Unsecured loans have no specific asset connected to the debt

which makes them riskier to provide.

 Repayment structure

o Debt is repaid in a number of different ways which impacts the

risk of the instrument and has associated advantages and
disadvantages.

o Installment loans - repaid in evenly or in stages over the term.

o Bullet loanLinks to an external site. - interest is paid regularly

but capital paid as a lump-sum at the end.

o Zero coupon loanLinks to an external site. - no cash flows

happen until the end at which point both capital and interest
are paid.

 Term of the debt

o This refers to how long the debt contract is for. It is normally

important to try to match the term of the finance with the
term of the assets of the company. i.e., don’t buy a car over
20 years and don’t buy a house over 5 years. It creates
mismatch risk.

o Medium-term = between +/- 3 and 10 years.

o Long-term = +/- 10 years and longer.

Debt Instruments (Bonds/Debentures)

Bonds / Debentures

A company bond is an instrument of indebtedness of the issuing company

to the bondholders. Bonds are normally longer-term debt instruments,
with maturity of at least one year but typically more which are issued to
and trade in the capital bond markets. Instruments with shorter
maturities (less than 1 year) are usually referred to as commercial
paper (CP's) and are issued to and trade in the money market.Links to an
external site.

A debenture is in substance the same thing as a bond and these words are
used relatively interchangeably.

As a quick introduction read this article and watch the video on debt
securities (debt instruments).Links to an external site.

Main terms of a bond / debenture

 Repayment conditions (bullet vs amortised)

 Coupon rate (usually fixed interest payment)

 Is there security over certain assets?

 Are there restrictive covenants to reduce risk and protecting the

bondholder?

o Clauses restricting the freedom of managements decisions

o Ensure financial ratios are within agreed limits

o Restrict raising of further loans

o Restrict the payment of dividends etc.

Other characteristics of bonds / debentures

 Convertibility - similar to preference shares a bond may be

convertible into ordinary shares.

 Participating - similar to preference shares a bond may have clauses

allowing for higher income if certain targets are met.

Debt Instruments (Bank loans)

Bank loans

In South Africa bank loans far exceed bonds as a source of debt finance.
Particularly with small and medium sized companies.

These loans are not specifically standardised and can be highly negotiated
between the bank and the company.

But typically, they take the following form:

 Interest rate - usually variable and connected to prime (but can be

fixed)
  Repayment structure - usually amortising meaning that capital is
repaid over the term of the loan.

 Typically secured - banks are often reluctant to not have security

and so either assets are sued as security or personal security is
often provided.

 Sometimes they also have restrictive covenants.

We're now done with our review of debt instruments and can move onto
hybrid instruments like preference shares.

Hybrid Instruments

Preference shares

Preference shares are called this because preferred shareholders have a

higher claim on the issuing company's assets than common shareholders.

Preference shares are provided a more secure dividend payment at a fixed

rate while ordinary shareholders do not have this promise. In exchange
for this secure dividend the preference shareholders give up the voting
rights that ordinary shareholders have.

In substance a preference share is a hybrid instrument as it has

characteristics of equity and debt; with debt like features such as a
defined dividend and possibly a defined redemption date and amount, and
equity like features as outlined in greater detail below.

Preference shares often have one or more of the following unique

features:

 Callable Shares

Callable shares are preference shares that the issuing company can
choose to buy back at a fixed price in the future. Because the issuing
company has the option to do this or not, this feature benefits the issuing
company. If the value of the preferred share exceeds the set price the
company will be able to buy back the share at a discount. If the value
does not exceed the set amount the company can choose to not buy it
back. Callable shares ensure the company can limit its maximum liability
to preferred shareholders.

 Convertible Shares

Convertible shares are preference shares that can be converted into

ordinary shares at a fixed rate or price. Depending on who has the right
to convert the shares will determine who it benefits (issuing company or
the shareholder). This is a common feature in venture capital finance
where the financier wishes to ensure that if things go well it can get
access to the value of ordinary shares but if things go badly its investment
is preferred to ordinary shareholders.

 Cumulative Shares

Preference shares that include a cumulative clause protect the

shareholder against a downturn in company profits. If revenues are down,
the issuing company may not be able to afford to pay dividends.
Cumulative shares require that any unpaid dividends must be paid to
preference shareholders before any dividends can be paid to ordinary
shareholders.

 Participatory Shares

Participatory preference shares provide an additional profit guarantee to

preference shareholders. Participatory preference shares guarantee
additional dividends in the event that the issuing company meets certain
financial goals such as profit targets at which point participatory
shareholders receive dividend payments above the normal fixed rate.

Tax treatment of preference shares

We have touched on this before but it’s important to reiterate that a

preference share is seen as a share and the payments as a dividend and
therefore the company does not get a tax deduction on the dividend
payment. This impacts on the comparative true cost between preference
shares and debt.