Cost of Preferred Stock

The cost of preferred stock is the rate or return investors expect to receive based on the market price of the stock and the annual dividend amount.

What is the Cost of Preferred Stock?

The cost of preferred stock to the company is effectively the price it pays in return for the income it gets from issuing and selling the stock. In other words, it’s the amount of money the company pays out in a year divided by the lump sum they got from issuing the stock.

Management often uses this metric to determine what way of raising capital is most effective and efficient. Corporations can issue debt, common shares, preferred shares, and a number of different instruments in order to raise funds for expansions or continuing operations. They calculate the cost of preferred stock formula by dividing the annual preferred dividend by the market price per share. Once they have the rate, they can compare it to other financing options. The cost of preferred stock is also used to calculate the Weighted Average Cost of Capital.

What is Preferred Stock?

Preferred stock is commonly issued to fund new developments and projects a firm wants to complete in the future. This allows the company to raise capital and dilute the current ownership percentages of the common shareholders because preferred shares don’t have voting rights. Preferred stock is also a more flexible option to a typical bond.

Preferred stock is different from common stock in several ways. Holders are first in line for any dividend payments. Holders also get priority in receiving their money back if the company goes into liquidation. This guarantee of receiving some or all the purchase price back means preferred stock is a mix of equity security, like common stock, and a debt security, like a bond. Typically, a preferred stock dividend is also considered a perpetuity. For this reason, the cost of preferred stock formula mimics the perpetuity formula closely.

The cost of preferred stock formula:

Rp = D (dividend)/ P0 (price)

For example:

A company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock?

Rp = D / P0

Rp = 3 / 25 = 12%

It is the job of a company’s management to analyze the costs all of these options and pick the best one. Since preferred shareholders are entitled to dividends each year, management must include this in the price of raising capital with preferred stock.

For investors, the cost of preferred stock, once it has been issued, will vary like any other stock price. That means it will be subject to supply and demand in the market. In theory at least, preferred stock may be seen as more valuable than common stock as it has a greater likelihood of paying a dividend and offers a greater deal of security if the company folds.

Cost of Preferred Stock Calculator

Feel free to peruse this free cost of preferred stock calculator to determine the cost of preferred stock for any sets of data. The calculator also contains the dividend discount model, which takes into account the possibility of a constant growth rate.

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