## **Learning Outcomes**

By completing this article, you will understand how to value preference shares, calculate their yield, and distinguish preference shares from ordinary shares for the ACCA Financial Management exam. You will learn the formulas, differences, exam pitfalls, and how to apply preference share pricing and yield calculations to sample questions.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand how both equity and preference shares are valued by investors and how companies determine their cost. This is essential for calculating the overall cost of capital (WACC) and making sound financing decisions. Focus your revision on:

- The nature and features of preference shares versus ordinary equity
- The calculation of preference share price (valuation) using perpetuity formulas
- How to compute the cost or yield of preference shares from current price and dividend
- The role of preference shares in the capital structure and impact on WACC
- The difference between redeemable and irredeemable (perpetual) preference shares
- Typical exam pitfalls in preference share valuation

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Which feature differentiates preference shares from ordinary shares?
   a) Preference shares receive variable dividends,
   b) Preference shares rank above ordinary shares for dividends,
   c) Preference shares carry full voting rights,
   d) Ordinary shares receive fixed dividends.
2. If a \$1 preference share pays an annual fixed dividend of 8c and is currently trading at \$1.10, what is its yield (cost)?
3. How is the value of an irredeemable preference share calculated?
4. State one reason why preference shares generally have a lower cost than ordinary equity.

## **Introduction**

Preference shares are a common instrument used by companies to raise finance with fixed dividend obligations. For exam purposes, you must be able to calculate both the value and yield (cost) of preference shares, and contrast them with ordinary shares.

This article provides a direct, exam-focused approach to preference share valuation, covering the formulas, calculation steps, and potential pitfalls. Correct application of these principles is essential for the WACC calculation and effective evaluation of financing options.

> **Key Term: preference share**
> A class of share that entitles the holder to a fixed dividend, paid before any ordinary (equity) dividends, but usually with limited or no voting rights.

## **VALUATION OF PREFERENCE SHARES**

Preference shares (sometimes called preferred shares) typically pay a fixed annual dividend, expressed as a percentage of their nominal value (e.g., 8% on \$1 par). They are often issued as irredeemable, meaning they have no maturity date, and the payment continues indefinitely unless the company winds up or chooses to redeem them.

To value an irredeemable preference share:

$$
P_0 = \frac{D}{K_p}
$$

Where:

- $P_0$ = current ex-dividend market price of the share
- $D$ = annual preference dividend (in $)
- $K_p$ = investors' required return or yield (expressed as a decimal)

> **Key Term: irredeemable preference share**
> A preference share with no fixed redemption date, paying dividends in perpetuity.

If the price and dividend are known, you can rearrange the formula to find the yield (cost to the company):

$$
K_p = \frac{D}{P_0}
$$

## **CALCULATING YIELD (COST) OF PREFERENCE SHARES**

The cost of irredeemable preference shares is simply the annual fixed dividend divided by the current ex-dividend market price:

$$
\text{Cost of preference shares} = K_p = \frac{\text{Dividend}}{\text{Market price}}
$$

This gives the return required by investors, and represents the company's cost of this source of finance. Note:

- No adjustment for tax is made, as dividends are not tax-deductible.
- Always use the ex-dividend price for calculations.

### **Worked Example 1.1**

A company has 20,000 9% preference shares, \$1 nominal value, trading at \$1.20 each (ex-div). What is the cost (yield) of these preference shares?

> **Answer:**
> Annual dividend per share = 9% × \$1 = \$0.09  
> Market price = \$1.20  
> $$ K_p = \frac{0.09}{1.20} = 0.075 = 7.5\% $$
> The cost (yield) is 7.5%.

### **Worked Example 1.2**

Kappa Ltd has \$100,000 irredeemable 8% preference shares trading at \$0.90 ex-div. What is the value of one share if the market required yield rises to 12%?

> **Answer:**
> Dividend per share = 8% × \$1 = \$0.08  
> Required yield = 12%  
> $ P_0 = \frac{0.08}{0.12} = \$0.6667 $  
> The value falls to about \$0.67 per share if yield increases to 12%.

## **PREFERENCE SHARES IN THE COST OF CAPITAL**

Preference shares are considered hybrid securities—less risky than ordinary shares (due to fixed dividends and higher claim on assets) but riskier than debt (as dividends are not a legal obligation and can be skipped).

- The cost of preference shares is usually lower than equity, but higher than debt (due to non-tax-deductibility and lower claim on assets).
- Redeemable preference shares (i.e., with a set maturity) require a different valuation approach, similar to redeemable debt (not examined in basic FM).

> **Key Term: cost of preference shares**
> The annual dividend divided by the ex-dividend market price, representing the company's required return for this funding.

## **COMPARISON WITH ORDINARY SHARES**

Preference shares:

- Fixed dividend, priority over ordinary dividends
- Usually no voting rights
- Generally irredeemable (may be redeemable in some cases)
- Cost calculation: $ K_p = D/P_0 $, not adjusted for corporation tax

Ordinary shares:

- Variable dividend, paid after preference dividends
- Full voting rights
- Cost calculated using the dividend growth model or CAPM, typically higher due to greater risk

### **Revision Tip**

Remember: For irredeemable preference shares, only the perpetuity formula is required. Never apply tax adjustments to preference share cost, as dividends are not tax-deductible.

### **Exam Warning**

A frequent exam error is to mistakenly use the cost of debt (and adjust for tax) for preference shares. This is incorrect—always use the full dividend with no tax adjustment for preference shares.

## **Summary**

- Value irredeemable preference shares using the perpetuity formula: price = dividend / required yield.
- The yield or cost is calculated as dividend divided by market price.
- Preference dividends are paid before ordinary dividends but are not tax-deductible.
- For ACCA FM, focus calculations on irredeemable (perpetual) preference shares unless the exam clearly states otherwise.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Value preference shares and calculate yield (cost) using the perpetuity formula
- Distinguish features of preference shares versus ordinary shares
- Correctly apply cost of preference shares in WACC calculations
- Recognize common exam pitfalls with tax adjustment and formula selection

## **Key Terms and Concepts**

- preference share
- irredeemable preference share
- cost of preference shares

Cost of equity and preference shares - Preference share valuation and yield