Cost of Preferred Stock


Preferred stock dividends are not tax-deductible to the company that issues them. Because they are paid out of after-tax cash flows, the issuing company does not have to make a tax adjustment.

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

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


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?

Component Cost of Preferred Stock = \(r_{ps} = \dfrac{$7.50}{$85.00} = 0.0882\) 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 is 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?
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