Cost of Preferred Stock

Rate or return investors expect to receive

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.

 

Cost of Preferred Stock theme

 

What is Preferred Stock?

Preferred stock is another form of equity that may be used to fund expansion projects, or developments that firms seek to engage in. Like other equity capital, preferred stock allows companies to raise funds. The preferred stock has the benefit of not diluting the ownership stake of common shareholders, as preferred shares do not hold the same voting rights that common shares do.

The preferred stock lies in between common equity and debt instruments, in terms of flexibility. It shares most of the characteristics that equity does, and is often known as equity. However, preferred stock also shares a few characteristics of bonds, such as a par value. Common equity does not often hold a par value.

 

Preferred, Common and Debt

Preferred stock differs from common equity in several ways. A beneficial distinction is that preferred shareholders are first in line to receive any cumulative dividend payments, or dividend payments in arrears. In the event of liquidation, preferred shareholders are also the first to receive payments after bondholders, but before common equity holders. As stated above, the par value is guaranteed on return.

 

Because of the nature of preferred stock dividends, it is also sometimes known as 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.

 

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Cost of Preferred Stock Calculator

 

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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