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12.3 Cost of Preferred Stock

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Understand the components of preferred stock.
  2. Explain how preferred stock is a part of the weighted average cost of capital.

Preferred stock dividends are not tax deductible to the company who issues them. Preferred stock dividends are paid out of after-tax cash flows so there is no tax adjustment for the issuing company.

When investors buy preferred stock they expect to earn a certain return. The return they expect to earn on preferred stock is denoted rps.

Dps is the dividend from preferred stock, Pps is the price of preferred stock.

Equation 12.3 Cost of Preferred Stock

Component Cost of Preferred Stock=rps=DpsPps

Worked Example: Falcons Footwear

Falcons Footwear has 2 million shares of preferred stock selling for $85/share. Its annual dividend is $7.50. What’s the rps?

Component Cost of Preferred Stock=rps=$7.50$85.00=0.0882 or 8.82%

Typically the cost of preferred stock is higher than the after-tax cost of debt. This is because of both the tax deductibility of interest and the fact that preferred stock is riskier than debt.

Key Takeaways

  • Preferred stock is a hybrid security—it’s both debt and equity.
  • Preferred stock return is calculated as its dividend divided by its price.

Exercises

  1. Calculate the component cost of preferred stock given the following: Company A has $10 million in preferred stock selling for $100 each and pays a dividend of $7.80. What’s the rps?
  2. Why is there no tax-adjustment made to our calculation of preferred stock?