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Dear all,
Does anybody know why in the answer to that question for preference shares we calculate the after tax cost of preference shares this way?
In the answer there is:
5% x $10m/$6.25m = 8%, but I’m still confused why it is calculated this way and not the other way around – $6250000/500000 which then gives 12.5% ( similar to calculation of cost of bonds -> market value divided by book value and multiplied by nominal)
I am clearly missing something, but can’t figure out what exactly that may be.
Thank you in advance for clarification!
The cost of preference shares is calculated in exactly the same way as the cost of equity shares, but obviously with a growth rate of 0%.
It is always the dividend/market value (it makes no difference whether you do it is total or per share – the answer is obviously the same).
It is also exactly the same as the calculation for irredeemable debt, except that with debt borrowing the interest is tax allowable and so it is the after-tax interest/market value (again it makes no difference whether you do it in total or per bond (i.e per $100 nominal).
(For redeemable debt (which is much more common in the exam) it has to be calculating the IRR).
It would make no sense at all, in either case, to divide the market value by the interest!!I do suggest that you watch my free lectures on the cost of capital where this is all explained in detail, with examples.
(The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.)
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