Cost of Preferred Stock

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 \(r_{ps}\).

\(D_{ps}\) is the dividend from preferred stock, \(P_{ps}\) is the price of preferred stock.


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 \(r_{ps}\)?

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 \(r_{ps}\)?
  2. Why is there no tax-adjustment made to our calculation of preferred stock?