Cost of Capital

Cost of Preferred Stock

Learning Objectives

Understand the components of preferred stock.
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 r_ps.

D_ps is the dividend from preferred stock, P_ps is the price of preferred stock.

Equation 12.3 Cost of Preferred Stock

$\text{Component Cost of Preferred Stock } = r_{ps}=\dfrac{D_{ps}}{P_{ps}}$

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?

$\text{Component Cost of Preferred Stock } = r_{ps}=\dfrac{$7.50}{$85.00} = 0.0882 \text { or } 8.82\%$

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

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 r_ps?
Why is there no tax-adjustment made to our calculation of preferred stock?