Valuation of Preference Shares.
Preference shares have preference over ordinary shares in terms of payment of dividend and repayment of capital if the company is wound up.
Preference shares may be issued with or without a maturity period. Redeemable preference shares are shares with maturity. Irredeemable preference shares are shares without any maturity.
The holders of preference shares get dividends at a fixed rate. With regard to dividends, preference shares may be issued with or without cumulative features.
Also read | Repossession in Hire Purchase.
In the case of cumulative preference shares unpaid dividends accumulate and are payable in the future. Dividends in arrears do not accumulate in the case of non-cumulative preference shares.
Preference shares are hybrid securities as they have features of a bond as well as of equity shares. They are less risky because their dividends are specified and are paid before equity shares.
Dividend on preference shares is assumed to be perpetual payments. To value a perpetuity, imply take the annual return and divide it by an appropriate discounted rate.
Also read | Dependent and Independent Branches.
The annual return of a preference share would be dividend rate, which is found by taking the discount rate and multiplying it by par value of the preference share.
Formula for Valuing Preference Shares:
P0 = D / r0 or r = D / P0
- D = annual dividend.
- r = investors required rate of return i.e. current yield.
- P0 = value of the perpetuity today.
Also read | Debtor System of Accounting in Branch Accounts.
Illustration: Consider that a company has issued Rs.100 preference share on without it pays a dividend of Rs. 9. Assume that this type of preference share is currently yielding a dividend of 11 per cent.
What is the value of the preference share? The preference dividend of Rs. 9 is perpetuity. Therefore, the present value of the preference share is:
P0 = D / r0
= 9 / 0.11 = Rs. 81.82
Also read | Circumstances under which a firm is dissolved.
Similarly, if market price is known and current yield on preference shares is not given it can be found by dividing the dividend by market price. So in the above example it will be calculated as:
r = 9 / 81.92 = 11%
Preference share may be redeemable (callable) after a period. The probable call date is used as an investment date to evaluate.