Understanding the Cost of Preferred Stock: A Key Capital Metric

The cost of preferred stock to a 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 cost-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 by dividing the annual preferred dividend by the market price per share. Once they have determined that 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.WACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt.

What is Preferred Stock?

Preferred stock is a form of equity that may be used to fund expansion projects or developments that firms seek to engage in. Like other equity capital, selling preferred stock enables companies to raise funds. 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.

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

Preferred vs Common Stock vs Debt

Preferred stock differs from common equity in several ways. A beneficial distinction is that preferred shareholders are first in line to receive any dividend payments. In the event of liquidation, preferred shareholders are also the first to receive payments after bondholders, but before common equity holders.

Because of the nature of preferred stock dividends, it is also sometimes known as a perpetuityPerpetuityPerpetuity is a cash flow payment which continues indefinitely. An example of a perpetuity is the UK’s government bond called a Consol.. 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 share 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 of all financing options and pick the best one. Since preferred shareholders are entitled to dividends each year, management must include this in the price of raising capitalInvestment BankingInvestment banking is the division of a bank or financial institution that serves governments, corporations, and institutions by providing underwriting (capital raising) and mergers and acquisitions (M&A) advisory services. Investment banks act as intermediaries 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 forces in the market. In theory, 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 amount of security if the company folds.

Cost of Preferred Stock Calculator

This Excel file can be used for calculating the cost of preferred stock. Simply enter the dividend (annual), the stock price (most recent) and the growth rate or the dividend payments (this is an optional field).

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Check out these additional CFI resources to help you along your finance career path:

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