Cost of Preferred Stock

Meaning Of Cost of Preferred Stock

To a company, the cost of preferred stock is effectively the price it pays in exchange for the income it receives from the issuance and sale of the preferred stock. In other words, it is the amount of money the company pays out in a year divided by the amount of money they received as a lump sum from the stock offering.

This metric is frequently used by management to determine which method of raising capital is the most effective and cost-efficient. Corporations can raise funds through the issuance of debt, common stock, preferred stock, and a variety of other instruments in order to fund expansion or ongoing operations. They arrive at the cost of preferred stock by dividing the annual preferred dividend by the current market price per share of the preferred stock. Once they have determined the interest rate, they can compare it to the rates offered by other lending institutions. It is also necessary to consider the cost of preferred stock when calculating the Weighted Average Cost of Capital.

In most cases, unless there are exceptional circumstances, the cost of preferred equity has no significant impact on the ultimate valuation of the company.

As a result, if the preferred equity amount is insignificant, it could be grouped with debt, with the resulting net impact on the valuation being minimal.

Preferential stock, on the other hand, should still be properly accounted for in a proper calculation of the value of a company.

Cost of Preferred Stock Formula

The dividend yield on the preferred equity securities that were issued is represented by the cost of preferred stock. The cost of preferred stock is equal to the preferred stock dividend per share (DPS) divided by the price per preferred share at which the preferred stock was issued as a dividend.

Preferred stock, like common stock, is typically assumed to be in perpetuity – that is, to have an unlimited useful life and to pay a fixed dividend payment that will never be reduced or eliminated.

As a result, the cost of preferred stock is analogous to the perpetuity formula, which is used to determine the value of bonds and debt-like instruments such as corporate bonds.

The dividend per share (DPS) is typically expressed as a percentage of the par value of the stock or as a fixed dollar amount. The annual preferred dividend payment divided by the current share price of preferred stock is the formula for calculating the cost of preferred stock.

Here, we are assuming the most straightforward variation of preferred stock, one that does not have any convertibility or callability features.

With a discount rate applied to account for the risk associated with preferred stock and the opportunity cost of capital, the present value (PV) of its periodic dividends (i.e., the cash flows to preferred shareholders) equals its fair market value (FMV).

The formula can be rearranged to produce the formula in which the cost of preferred stock (also known as the discount rate) is equal to the preferred dividend per share divided by the current price of preferred stock.

Cost of Preferred Stock = Preferred Stock Dividend Per Share (DPS) / Current Price of Preferred Stock

Example

Preferred Stock Dividend Per Share (DPS) = 4

Current Price of Preferred Stock = 50

Solution:

Cost of Preferred Stock = 4/50 = 8%