Explanation : A popular approach to estimating the cost of equity is the capital asset pricing model (CAPM) relationship. According to the CAPM, the required return on a company’s equity is: Risk-free rate + Beta × Market risk premium. Analysts who do not have faith in the CAPM approach often resort to a subjective procedure to estimate the cost of equity. They add a judgemental risk premium to the observed yield on the long-term bonds of the firm to get the cost of equity.
Explanation : As the name indicates, preference shares are the shares of a firm with preferential treatment compared to ordinary equity shares. As a
source of long-term finance, preference shares are given preference in payment of dividends and also preference in distribution of assets
in case of liquidation of the firm. Section 85 of the Companies Act 1956 defines preference shares as having the following two
(i) These shares have preferential right to be paid dividend at a fixed rate; and
(ii) These shares have preferential right to the return of capital in case of liquidation.
The main attributes of preference shares/ capital are discussed below.
Prior Claim on Income/Assets : Preference share/capital has a prior claim/preference over equity share/capital both on the income and
assets of the company. In other words, preference dividend must be paid in full before payment of any dividend on the equity capital
and, in the event of liquidation, the whole of preference share/capital must be paid before anything is paid to the equity share/capital.
Thus, preference share/capital stands midway between debentures and equity as regards claims on the income and assets of the
company. It is also referred to as a senior security. Stated in terms of risk perspective, the preference share is less risky than ordinary
shares but more risky than debentures.
Cumulative Dividends : The preference share is cumulative, in the sense that all unpaid dividends are carried forward and payable before any ordinary dividend is paid.
Redeemability : The preference share has a limited life/specified/fixed maturity (typically 7 years) after which it must be retired.
However, there are no serious penalties for breach of redemption stipulation.
Fixed Dividend : Preference share dividends are fixed and expressed as a percentage of par value. Yet, it is not a legal obligation and failure to pay will not force bankruptcy. Preference shares are also called a fixed income security.
Convertibility : Preference shares may sometimes be convertible partly/fully into equity shares/debentures at a certain ratio
during a specified period. A variant in India is the cumulative convertible preference shares that combines the cumulative and
convertibility features. It has, however, been a virtual non-starter so far.
Voting Rights : A preference share ordinarily does not carry voting rights. It is, however, entitled to vote on every resolution if (i) the
preference dividend is in arrear for two years with respect to cumulative preference sharesor (ii) the preference dividend has not been
paid for a period of two or more consecutive preceding years or for an aggregate period of three or more years in the preceding six years
ending with the expiry of the immediately preceding financial year.
Participation Features : The preference share may be participating or entitling participation in surplus profits, if any, that is,
profit after payment of preference dividend and equity dividend, at a certain specified rate. Similarly, it may be entitled to participate in the residual assets after the payment of their normal claim, according to a specified formula, in the event of liquidation of the company.
Explanation : Following are six factors that affect a company’s dividend policy (decisions about whether and in what amount to pay dividends):
> Investment opportunities.
> The expected volatility of future earnings.
> Financial flexibility.
> Tax considerations.
> Flotation costs.
> Contractual and legal restrictions.
Boards of directors and managers spend considerable time setting dividend policy despite the lack of clear guidance from theory to guide their deliberations.
Explanation : Shareholder Wealth Maximization (SWM): SWM means maximizing the net present value of a course of action to shareholders.
Net present value (NPV) or wealth of a course of action is the difference between the present value of its benefits and the present value of
its costs. A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A financial action
resulting in negative NPV should be rejected since it would destroy shareholders’ wealth. Between mutually exclusive projects the one with the highest NPV should be adopted. NPVs of a firm’s projects are addititive innature. That is:
NPV (A) + NPV (B) = NPV (A + B)
This is referred to as the principle of valueadditivity. Therefore, the wealth will be maximized if NPV criterion is followed in making financial decisions.
The objective of SWM takes care of thequestions of the timing and risk of the expected benefits. These problems are handled
by selecting an appropriate rate (the shareholders’ opportunity cost of capital) for discounting the expected flow of future
benefits. It is important to emphasise that benefits are measured in terms of cash flows. In investment and financing decisions, it is
the flow of cash that is important, not the accounting profits. The objective of SWM is an appropriate andoperationally feasible criterion to choose among the alternative financial actions. It provides an unambiguous measure of what financial management should seek to
maximize in making investment and financing decisions on behalf of shareholders. Maximizing the shareholders’ economic
welfare is equivalent to maximizing the utility of their consumption over time. With their wealth maximized, shareholders can adjust
their cash flows in such a way as to optimize their consumption. From the shareholders’ point of view, the wealth created by a
company through its actions is reflected in the market value of the company’s shares. Therefore, the wealth maximization principle
implies that the fundamental objective of a firm to maximize the market value of its shares. The value of the company’s shares is
represented by their market price which in turn, is a reflection of shareholders’ perception about quality of the firm’s financial decisions.
The market price serves as the firm’s performance indicator.