Financial Management · Estimating the cost of capital

Cost of Preference Shares and Bank Debt in ACCA FM

Updated 11 October 2026 · Fact-checked

Irredeemable preference shares cost = fixed dividend ÷ ex-div market price, with no tax adjustment because dividends are paid from after-tax profit. Bank loan cost = interest rate × (1 − tax rate) when the loan is not repaid at a premium or discount, because interest is tax deductible.

Understand Cost of Preference Shares and Bank Debt

Every source of finance has a cost. It is the return the provider expects for the risk they take. In FM you estimate this cost so you can build a weighted average cost of capital (WACC) and discount projects.

Preference shares pay a fixed dividend each year. Holders rank ahead of ordinary shareholders for dividends and on liquidation, but behind lenders. Most exam questions treat them as irredeemable, so the dividend continues forever. A perpetuity with a fixed payment has a value of payment ÷ return. Rearrange this and the cost is dividend ÷ price.

Tax treatment is the key difference. Preference dividends are a distribution of profit, not an expense. The company gets no tax deduction. So the cost is not adjusted for tax. Bank loan interest is an expense that reduces taxable profit. The company saves tax equal to interest × tax rate, so the after-tax cost is lower.

Bank debt is usually not traded, so it has no market price. If it is repaid at par, you take the interest rate and multiply by (1 − tax rate). If it is redeemable at a premium or discount, or the loan is traded, you find the after-tax IRR of the cash flows instead. The same applies to redeemable preference shares: use an IRR on the price, dividends and redemption value, with no tax.

Remember to use the market price, not the nominal value, as the value of the share. Use the ex-div price, because the next dividend is the one a new buyer will receive.

Key rules to remember

Cost of irredeemable preference shares: Kp = D ÷ P₀; D is the fixed annual dividend (nominal value × dividend rate). P₀ is the ex-div market price. No tax adjustment.
Cost of bank loan (repaid at par): Kd = i × (1 − T); i is the interest rate on the loan. T is the corporate tax rate. Use when the loan is repaid at par and has no market price.
Cost of redeemable debt or preference shares: Find the rate r where: Present value of cash flows = current price; Use IRR with two trial rates and interpolation. For debt use after-tax interest. For preference shares use the dividend with no tax.
Interpolated IRR: IRR = L + [NPV_L ÷ (NPV_L − NPV_H)] × (H − L); L and H are the low and high trial rates. NPV_H is usually negative.
Annual tax saving on interest: Tax saving = interest × T; Tax relief may be delayed by a year if the question says tax is paid with a lag.

How to solve Cost of Preference Shares and Bank Debt questions

Use this method for any question on the cost of preference shares or bank debt.

1Identify the instrument: preference share or loan. Decide whether it is irredeemable or redeemable.
2Find the fixed payment. For preference shares, work out dividend = nominal value × rate. For loans, work out interest = amount × rate.
3Decide on tax. Preference dividends get no relief. Loan interest gets relief at the tax rate given.
4Find the value to use. For preference shares use the ex-div market price. For a bank loan with no market price, use the interest rate and apply the tax adjustment.
5If the instrument is irredeemable, apply the simple formula. If redeemable or at a premium or discount, set up cash flows and calculate the IRR.
6For IRR, pick two discount rates, calculate NPVs, then interpolate. Check that the answer lies between your two trial rates.
7State the answer as a percentage with one or two decimal places, and say whether it is before or after tax if the question asks.

Quickest way: Pre-tax or post-tax, then divide

When to use it: Use for Section A and OT case questions where the instrument is irredeemable or the loan is repaid at par.

Preference shares: compute dividend in ₹ or $ and divide by the ex-div price. Stop. No tax.
Bank loan at par: multiply the interest rate by (1 − tax rate). Stop.
If the price is cum-div, subtract the dividend due first.
Only use IRR if the question gives a redemption value different from the loan amount, or a market price for debt.

Common mistakes in Cost of Preference Shares and Bank Debt

Adjusting the cost of preference shares for tax.
Students treat dividends like interest because both are fixed payments.
Fix: Dividends come from after-tax profit. No relief, so Kp = D ÷ P₀ with no (1 − T).
Using the nominal value as the denominator.
The share is described as a $1 preference share and the student divides by $1.
Fix: Divide by the market price. Nominal value only sets the dividend amount.
Forgetting tax relief on bank loan interest.
Students quote the interest rate directly as the cost.
Fix: Multiply by (1 − T) unless the question says the company pays no tax or the answer is requested pre-tax.
Calculating the preference dividend as a percentage of market price.
Confusion between the dividend rate and the yield.
Fix: Dividend = rate × nominal value. Then divide by market price to get the yield.
Using the cum-div price without adjustment.
Students miss the words cum div in the question.
Fix: Subtract the imminent dividend from the price first to get the ex-div price.
Applying the simple formula to redeemable instruments.
Students see a fixed dividend or interest and stop there.
Fix: If there is a redemption date and value, use IRR on the full cash flow pattern.

Worked examples

Example 1

A company has 8% irredeemable preference shares with a nominal value of $1 each. The current ex-div market price is $0.80 per share. Corporate tax is 25%. Calculate the cost of the preference shares.

Show the solution

Annual dividend per share = 8% × $1 = $0.08.
Preference dividends receive no tax relief, so the tax rate is ignored.
Kp = D ÷ P₀ = 0.08 ÷ 0.80 = 0.10.

Answer: The cost of the preference shares is 10%.

Example 2

A company has a bank loan of $2,000,000 at an interest rate of 7%, repaid at par. Corporate tax is 30% and tax is paid in the same year as the profits arise. Calculate the after-tax cost of the loan, and the annual tax saving on interest.

Show the solution

Annual interest = 7% × $2,000,000 = $140,000.
Annual tax saving = $140,000 × 30% = $42,000.
After-tax cost = 7% × (1 − 0.30) = 7% × 0.70 = 4.9%.
Check: after-tax interest = $140,000 − $42,000 = $98,000. $98,000 ÷ $2,000,000 = 4.9%.

Answer: The after-tax cost of the loan is 4.9%, and the annual tax saving is $42,000.

Exam tips

Check whether the question gives a cum-div or ex-div price before you divide. This is a common OT trap.
Write the dividend or interest in money terms first. It stops you using nominal value in the wrong place.
In OT questions the wrong options often include the tax-adjusted preference cost. Do not choose it.
In a WACC question, the preference share and bank loan costs are inputs. Work them out cleanly, then weight them by market values.
For Section C, show the formula and each figure used. Marks are awarded for method even if the arithmetic slips.

Practice questions from Estimating the cost of capital

Cost of Preference Shares and Bank Debt in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Preference Shares and Bank Debt: frequently asked questions

Do preference shares get tax relief in ACCA FM?

No. Preference dividends are paid out of after-tax profit, so the company gets no tax deduction. The cost of preference shares is dividend divided by ex-div market price, with no tax adjustment.

Why is bank loan cost lower after tax?

Loan interest is a tax-deductible expense. It reduces taxable profit, so the company pays less tax. The after-tax cost is interest rate × (1 − tax rate).

How do I cost redeemable preference shares?

Treat the current price as an outflow and the future dividends and redemption value as inflows. Find the IRR using two trial rates and interpolation. Do not adjust for tax.

Which price do I use for preference shares?

Use the ex-div market price. If the question gives a cum-div price, deduct the dividend about to be paid to get the ex-div price. Do not use nominal value as the price.