In the previous few articles we understood how to calculate free cash flows which accrue to the firm as a whole as well as to equity shareholders. However, while conducting this analysis we made an implicit assumption. We assumed that there are only two classes of funds available to the firm, this is equity and debt.

This assumption is good in the theoretical world. It helps us form a basic understanding of how free cash flows work. However, this is not how it works in real life. In real life, many hybrid modes of finance can possibly be used. One of the commonly used modes is preferred shares.

Just to refresh your memory, preferred shares behave partly like debt and partly like equity. They have a fixed rate of return. However, it is not mandatory for the company to pay this fixed dividend if there is no profit in the current year.

In this article, we will concentrate on how preferred shares affect the calculation of free cash flows.

Preferred Shares: Treated Like Debt:

As far as the cash flows are concerned preferred shares must be treated like debt. This is because they have a fixed rate of return and in most circumstances companies will end up paying the dividend that is fixed on them. The similarity to debt makes this assumption realistic.

Preferred Dividends Are Not Tax Deductible:

However, there is a subtle difference between the treatments of interest paid on debt and dividends paid on preferred shares. Interest paid on debt is tax deductible. However, legally preferred shares are considered to be a part of equity. It is for this reason that any compensation paid to the preferred shareholders is not considered as an expense for tax purposes.

In simple words, preferred shares are not tax deductible. This makes it necessary to make certain modifications while calculating the free cash flow due to equity as well as to the firm. Let’s discuss these modifications:

Calculating Free Cash Flow to Firm (FCFF):

The procedure to calculate the free cash flow to the firm (FCFF) remains the same. The only difference lies in the following adjustments:

• Add Back Preferred Dividends: Along with interest, we will also add back preferred dividends while calculating the free cash flow available to the firm. However, we usually reduce the interest tax shield from the interest amount. In case of preferred dividends, there is no tax shield. Hence the entire amount paid as preferred dividend simply needs to be added back to the cash flows to derive the free cash flow of the firm.

• Adjust The Weighted Average Cost of Capital (WACC):Also, the rate at which we discount the free cash flows has to be modified when we include preferred debt. Earlier we used to calculate WACC using only two components i.e. debt and equity.

Now, since there are three different modes of financing with three different costs, obviously our WACC will be the weighted average of all the three modes!

Calculating Free Cash Flow to Equity (FCFE):

While calculating free cash flow to equity, we have to use adjustment number one mentioned above i.e. add back preferred dividends. However, we must not use adjustment number two. This is because free cash flow to equity is discounted at cost of equity. It is not discounted at WACC.

However, there is another adjustment that is specific to the calculation of free cash flow to equity. The same has been mentioned below:

• Adjust Net Borrowing: Just like we made adjustments for debt while calculating free cash flow to equity, similarly we need to make adjustments to preferred equity as well.

All repayments need to be subtracted from the free cash flow to equity whereas any cash raised by new issue of preferred shares must be added to the cash flows. Once again, we need to consider the net change in the position of preferred equity if the firm is issuing more shares and repurchasing the old ones simultaneously.

To sum it up, preferred equity is a fairly common mode of financing used by companies. The adjustments that need to be made to the standard process of calculating free cash flows are very intuitive and minor. If a student is well versed with calculating free cash flows, the inclusion of preferred equity will not make much of a difference.