Preference shares; determinants of capital structure

Are preference shares a source of project finance?

Yes. Preference shares are a source of long-term finance with features of both equity and debt. The holders get a fixed rate of dividend, which is paid before any dividend to ordinary shareholders, and they have priority in repayment of capital if the company is liquidated. Usually, however, they have no voting rights.

• Advantages: no obligation to pay the dividend if profit is not enough (for non-cumulative shares), no dilution of control, no security required, and a larger equity base for borrowing.
• Disadvantages: the dividend is not tax-deductible (it is paid from after-tax profit), so preference capital costs more than a loan; it also creates a fixed claim ahead of ordinary shares.
• Types: cumulative, non-cumulative, redeemable, convertible and participating.

So a project can raise part of its capital through preference shares when it wants funds without losing control and without compulsory repayment.

Determinants of capital structure decision

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if it is lower, more debt reduces EPS.
3. Cost of capital: debt is cheaper because interest is tax-deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for a share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with a PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on the debt-equity ratio set by regulators, the tax rate, and lenders' covenants.
10. Risk (business and financial): a firm with high business risk should use less debt.