Cost of Preferred Stock
Cost of the preferred stock is the required rate of return of the preferred stockholders. The investors who purchase the preferred stock expect to receive a certain return from their investment. It is the ratio computing by annual dividend divided by the preferred stock current price.
Preferred stock consists of both common stock and bond features. It is the stock so there is no maturity date, however, the holder will guarantee to receive the fixed dividend which is similar to debt. Preferred stockholders are the owner of the company but they do not have the right to vote in the annual general meeting. But they have a higher claim on dividend distribution. They will receive the dividend before the common stockholders. And in the event of liquidation, preferred stockholders will be a priority to receive the company assets before the common stockholders.
The preferred stockholders are almost guaranteed to receive the annual dividend. This dividend will be shared with the preferred shareholder before the common shareholder. The dividend can be stated in dollar amount or percentage of the share price.
Cost of preferred stock is calculated by dividing the preferred stock dividend over the current price. As there is no limited life, the cash outflow will be infinity. The company has to pay the fixed dividend until they buy back the stock.
As we know that, preferred stockholders will receive the dividend for an unlimited time. The amount of dividend is a guarantee which is similar to interest income. However, the preferred stockholders will not be able to vote in the annual general meeting. In the event of liquidation, the preferred stockholder will have a greater right of claiming assets other than the common stockholder. In short, preferred stock contain both features of debt (bonds) and equity (commons stock).
Cost of Preferred Stock Formula
Cost of preferred stock is the cost that the company spends to issue the preferred stock. It is the comparison between annual dividends and share prices.
| Cost of preferred stock = Dividend per Share/ Price per Share |
Dividend is the cash paid from the issuer to raise cash by selling the preferred shares to the market. The company needs to compare the cost of preferred stock with other kinds of security to select the cheap one. The company may decide to issue a bond or common share if it is cheaper than the preferred stock.
Cost of Preferred Stock Example
Company ABC has issued 100,000 preferred stock which has a par value of $ 1,000 each. The annual fixed dividend is 8% of the par value. The market price of a preferred share is $ 1,500 per share. Please calculate the cost of the preferred share.
First, we need to calculate the dividend per share per year.
Annual preferred share dividend = 1,000 * 8% = $ 80
So we can calculate the preferred share cost as follows:
Cost of preferred share = 80/1,500 = 5.3%
Company needs to spend 5.3% per year on the selling price of the preferred share. So management needs to compare with the other source of capital such as bonds, bank loans, and common stock. They should take into account the nature of the preferred share which is different from the common share. The company will not lose ownership over decision-making if they issue preferred shares.
| Assumption of cost of preferred stock | |
|---|---|
| No Maturity Date | The preferred stock does not have the maturity date and the company will keep paying the dividend until they buy back the share. It is the feature of preferred stock that does not include maturity date. It is different from bonds which have a specific maturity date. |
| Stock is not convertible | We assume that the stockholders cannot convert to other types of security. The issuer needs to ensure that the preferred stock can not be converted to common stock or other types of security. |
| The company keep paying the dividend | There will be no delay in the dividend paid. Different from common stock, the company needs to keep paying the interest to preferred stockholders. |
Limitation of Cost of Preferred Stock
Convertible preferred stock: This module assumes that the preferred stock is nonconvertible. If the preferred stock is convertible, we will not be able to use this formula.
Company miss the dividend: We assume the company will keep paying the dividend to preferred stock forever. However, it may be the case when the company misses the dividend payment and the module will not work.
Preferred stock is indefinite: In theory, the preferred stock is indefinite, however, the company may redeem them when it is possible. When the company has surplus cash flow, they will be looking for a buyback of the preferred share in order to save cost.