--- title: "Preference shares; determinants of capital structure" subject: "Project Engineering" chapter: 6 key: "semester_7/project_engineering:sources-project-finance-preference-shares" source: https://www.bctengineer.com/q/semester_7/project_engineering/sources-project-finance-preference-shares site: BCT Engineering --- # Preference shares; determinants of capital structure Project Engineering · Chapter 6: Introduction to Project Financing - Asked in: 2076 Asoj, 2+4 marks - Video: [Corporate Management - Determining capital structure](https://www.youtube.com/watch?v=fRn5cdHShIw) — TutorialsPoint - Answer checked by Claude Opus 5.5 (high effort) on 2026-10-14 - Page: https://www.bctengineer.com/q/semester_7/project_engineering/sources-project-finance-preference-shares - Whole chapter: https://www.bctengineer.com/md/semester_7/project_engineering/chapter-6 ## Question Are preference shares a source of project finance? Explain it. Explain the determinants of the capital structure decision made in any business firm. ## Short answer Yes, preference shares are a long-term project finance source with fixed dividend before ordinary shares, priority in liquidation, and usually no voting rights; dividend is not tax-deductible, so they cost more than debt. Determinants of capital structure include cash flowability, leverage, cost of capital, control, flexibility, marketability, firm size, business nature, legal and tax factors, and business and financial risk. ## Answer #### 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. ## Check yourself The answer's key points as multiple-choice questions, with the correct option and why. 1. Are preference shares a source of project finance? A. No, they are only short-term loans B. Yes, they have features of both equity and debt C. No, they are government grants D. Yes, they are pure debt with tax-deductible interest Answer: B. They are long-term finance combining features of equity and debt. (Key point: Preference shares) 2. What is a disadvantage of preference shares? A. Dividend is tax-deductible B. They dilute control strongly C. Dividend is not tax-deductible, so cost is higher than debt D. They must be secured by assets Answer: C. Preference dividend is paid from after-tax profit. (Key point: Dividend tax) 3. What is an advantage of preference shares? A. Voting rights are given to holders B. Interest saves tax C. Fixed claim after ordinary shares D. No dilution of control and no compulsion to pay (non-cumulative) Answer: D. They usually carry no vote and no obligation to pay if profit is insufficient. (Key point: Advantage) 4. Why may owners prefer debt over new equity? A. New equity dilutes control B. Debt dilutes control C. Equity is always cheaper D. Debt has no payment Answer: A. Issuing new equity shares dilutes the control of existing owners. 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