Financial Management and Business Data Analytics · Cost of Capital

Cost of Preference Share Capital: Formula and Numericals

Q: What is the formula for cost of preference share capital?

For irredeemable shares it is Kp = D ÷ NP, where D is the annual dividend on face value and NP is the net proceeds after flotation costs. For redeemable shares it is Kp = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]. Use the second form whenever a redemption date is given.

Q: Why is dividend on preference shares not tax deductible in cost of capital?

Preference dividend is a distribution of profit after tax, not an expense of the business. Because the company gets no tax saving, its cost is not reduced by the tax rate. Interest on debt is an expense and gives a tax shield, which is why only the cost of debt is adjusted for tax.

Q: How do flotation costs and redemption premium change the cost?

Flotation costs reduce net proceeds, so the same dividend is spread over less money and the cost rises. A redemption premium raises the amount repaid, so the company bears extra cost and Kp rises. A discount on redemption works the other way.

Q: Is the cost of preference capital higher than the cost of debt?

Usually yes. Preference shares are riskier for the investor than debt, so they expect a higher return, and the company gets no tax shield on the dividend. This is a general pattern, not a rule that holds in every case.

Updated 10 October 2026 · Fact-checked

Cost of preference share capital is the annual dividend burden as a percentage of net money raised. For irredeemable shares, divide the annual dividend by net proceeds. For redeemable shares, add the yearly share of (redemption value − net proceeds) to the dividend, then divide by the average of redemption value and net proceeds. No tax adjustment applies.

Understand Cost of Preference Share Capital

Preference shares carry a fixed rate of dividend. The company promises it to the shareholders before any equity dividend is paid. The cost of preference share capital (Kp) is the return the company must earn on the money raised so that preference shareholders get what they expect.

Start with the dividend. It is always the stated rate multiplied by the face value, not the issue price. A 10% preference share of ₹100 face value pays ₹10 a year, even if it is sold at ₹95 or ₹105.

Next, find the net proceeds (NP). This is the issue price less flotation costs such as underwriting commission, brokerage and issue expenses. The company receives less than the issue price, so the effective cost is higher.

Then ask whether the shares will be repaid. Irredeemable preference shares are never repaid, so the cost is simply dividend ÷ net proceeds. Redeemable preference shares are repaid after n years at a redemption value (RV), which may include a premium. The difference between RV and NP is a gain or loss spread over the years, and it must be added to the dividend.

Preference dividend is paid out of profit after tax. It is an appropriation of profit, not an expense, so it gives no tax saving to the company. That is why the cost of preference capital is not multiplied by (1 − tax rate), unlike the cost of debt.

Key rules to remember

Annual preference dividend: D = Dividend rate × Face value; Always on face value, never on issue price or net proceeds.
Net proceeds: NP = Issue price − Flotation costs; If flotation cost is given as a % of face value, apply it to face value. If given as a % of issue price, apply it to issue price. Either way, deduct the cost from the issue price to get NP.
Cost of irredeemable preference shares: Kp = D ÷ NP; If no flotation cost is given and shares are issued at par, Kp equals the dividend rate. If a current market price is used, Kp = D ÷ market price.
Cost of redeemable preference shares (approximate method): Kp = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; RV is the redemption value including any premium; n is the years to redemption. This is the usual exam formula.
Cost of redeemable preference shares (exact method): NP = Σ D ÷ (1 + Kp)^t for t = 1 to n + RV ÷ (1 + Kp)^n; Kp is the discount rate that equates present value of dividends and redemption value to net proceeds. Solve by trial and interpolation, as for IRR.
Tax treatment: Kp is not adjusted for tax; Preference dividend is not a tax-deductible expense, so there is no tax shield.

How to solve Cost of Preference Share Capital questions

Use this order for any preference share cost question. Write each figure on a separate line so you earn step marks even if the final answer slips.

1Read whether the shares are redeemable or irredeemable. Look for words like 'redeemable after n years' or 'redeemed at a premium'.
2Calculate the annual dividend: rate × face value.
3Calculate net proceeds: issue price less flotation costs. Check whether the flotation cost is a percentage of face value or of issue price.
4Find the redemption value: face value plus any premium on redemption (or less any discount). Note n.
5Pick the formula. Irredeemable: D ÷ NP. Redeemable: [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2].
6Substitute the values, compute carefully and express the answer as a percentage, usually to two decimals.
7State clearly that no tax adjustment is made because preference dividend is not deductible. If the question asks, comment on why Kp is usually higher than the after-tax cost of debt.

Quickest way: Four-number shortcut

When to use it: Use it for MCQs and for the first pass of any numerical, when the shares are issued at par with no costs or the data is simple.

Write only four numbers: D, NP, RV, n.
If issued at par, with no flotation cost and no redemption premium, Kp equals the dividend rate. Stop there.
If irredeemable, divide D by NP and finish.
If redeemable, compute the numerator first: D + (RV − NP) ÷ n. Then the denominator: (RV + NP) ÷ 2. Divide.
Cross-check direction: if RV > NP, the term (RV − NP) ÷ n adds to the numerator, so Kp must be higher than D ÷ [(RV + NP) ÷ 2]. If RV < NP (redemption at discount), that term reduces the numerator, so Kp must be lower than D ÷ [(RV + NP) ÷ 2]. Do not compare with D ÷ NP without care, because the denominator also changes in the redeemable formula.

Common mistakes in Cost of Preference Share Capital

Calculating dividend on issue price or net proceeds instead of face value.
Students link the dividend to the money received, as they do with a yield.
Fix: Always compute D as dividend rate × face value. Use net proceeds only in the denominator.
Multiplying the cost of preference shares by (1 − tax rate).
The tax shield from the cost of debt is applied automatically.
Fix: Remember that preference dividend is paid from profit after tax and is not deductible, so no tax adjustment is made.
Ignoring flotation costs or deducting them from face value when they relate to issue price.
Students skim the question and miss the base on which the percentage is stated.
Fix: Compute the flotation cost on the stated base (face value or issue price) and deduct it from the issue price to get NP.
Using face value as RV when a redemption premium is given.
Students treat redemption as returning face value only.
Fix: RV = face value + premium. In the formula, RV is what the company actually pays at maturity.
Using the redeemable formula for irredeemable shares, or the reverse.
Students memorise one formula and apply it to every question.
Fix: Check for a redemption date first. No redemption date means Kp = D ÷ NP.
Dividing the average of RV and NP wrongly, for example by using (RV − NP) ÷ 2 in the denominator.
The numerator has a difference, so the sign gets carried over.
Fix: The numerator has (RV − NP) ÷ n. The denominator has (RV + NP) ÷ 2, a sum, because it is an average.

Worked examples

Example 1

Fortis Textiles Ltd issues 11% irredeemable preference shares of ₹100 face value at ₹96 per share. Flotation cost is ₹4 per share. Calculate the cost of preference share capital.

Show the solution

The shares are irredeemable, so use Kp = D ÷ NP.
D = 11% × ₹100 = ₹11 per share.
NP = ₹96 − ₹4 = ₹92 per share.
Kp = 11 ÷ 92 = 0.11957, that is 11.96%.
No tax adjustment is made because preference dividend is not tax deductible.

Answer: Cost of preference share capital = 11.96% (approx.)

Example 2

Kaveri Engineering Ltd issues 10% redeemable preference shares of ₹100 face value at par. Flotation cost is 5% of face value. The shares will be redeemed after 10 years at a premium of 5%. Calculate the cost of preference share capital.

Show the solution

The shares are redeemable, so use Kp = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2].
D = 10% × ₹100 = ₹10.
Flotation cost = 5% of face value = 5% of ₹100 = ₹5. NP = ₹100 − ₹5 = ₹95.
RV = ₹100 + 5% premium = ₹105. n = 10 years.
Numerator = 10 + (105 − 95) ÷ 10 = 10 + 1 = ₹11.
Denominator = (105 + 95) ÷ 2 = ₹100.
Kp = 11 ÷ 100 = 11%.
No tax adjustment is made. The exact IRR method would give a slightly higher rate, so state that 11% is the approximate cost.

Answer: Cost of redeemable preference share capital = 11% (approximate method)

Exam tips

Show D, NP, RV and n as separate lines before the formula. Examiners award marks for each correct input.
In MCQs, check the flotation cost base and whether the premium is on redemption or on issue. Wrong options are usually built from these slips.
If the question says 'ignore tax' or 'no tax', or says nothing, do not apply a tax factor to preference shares. Write one line explaining why.
When the question gives a market price, use it as the denominator for irredeemable shares. Use net proceeds when issue costs are given.
In WACC problems, calculate Kp first and carry it forward. Do not recompute it differently in the weighted average table.

Practice questions from Cost of Capital

Cost of Preference Share Capital 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 Share Capital: frequently asked questions

What is the formula for cost of preference share capital?

For irredeemable shares it is Kp = D ÷ NP, where D is the annual dividend on face value and NP is the net proceeds after flotation costs. For redeemable shares it is Kp = [D + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]. Use the second form whenever a redemption date is given.

Why is dividend on preference shares not tax deductible in cost of capital?

Preference dividend is a distribution of profit after tax, not an expense of the business. Because the company gets no tax saving, its cost is not reduced by the tax rate. Interest on debt is an expense and gives a tax shield, which is why only the cost of debt is adjusted for tax.

How do flotation costs and redemption premium change the cost?

Flotation costs reduce net proceeds, so the same dividend is spread over less money and the cost rises. A redemption premium raises the amount repaid, so the company bears extra cost and Kp rises. A discount on redemption works the other way.

Is the cost of preference capital higher than the cost of debt?

Usually yes. Preference shares are riskier for the investor than debt, so they expect a higher return, and the company gets no tax shield on the dividend. This is a general pattern, not a rule that holds in every case.