Cost of Preferred Stock

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 r ps .

D ps is the dividend from preferred stock, P ps 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 r ps ?

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. 1Calculate 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. 2Why is there no tax-adjustment made to our calculation of preferred stock?