Preferred stock is a type of equity capital used to finance a business. The cost of preferred stock arises from the dividends the business pays in return for the funding.
Preferred stock has no maturity date or right to vote but gives stockholders preferences over common stockholders. Such rights include the right to a fixed dividend and repayment in the event of liquidation of the business.
Issue Price of Preferred Stock Equity
Preferred stock can be issued at par, a premium or at a discount depending on market conditions at the time.
Since the stock has additional rights and therefore less risk than common stock equity the cost of preferred stock tends to be between the cost of common equity and the cost of debt finance.
Preferred stock has no maturity date and the fixed dividend can be viewed as an infinite series of payments (perpetuity). The value of this perpetuity and therefore the price of a preferred stock is given by the following perpetuity formula.
So for example if a business issues 8.1% preferred equity with a par value of 100 and the market rate of return is 7.2% then the share price of the preferred stock is calculated as follows.
Dividend rate = 8.1% Par value = 100 Rate of return = 7.2% Share price = Dividend / Rate of return Share price = (Dividend rate x Par value) / Rate of return Share price = 8.1% x 100 / 7.2% = 112.50
Given the dividend rate and the share price paid by the investor, the above formula can be rearranged to calculate the rate of return to the investor at any point in time.
Cost of Preferred Stock Formula
At the specific point when the preferred stock is issued the return to the investor is calculated as follows.
Since the business receives the investment (share price at issue) in return for the dividends it has to pay, the cost of preferred stock to the business is the same as the rate of return to an investor who buys the new issue.
Cost of Preferred Stock Example
Suppose a business issues 5.8% preferred stock with a par value of 100 at a discounted price of 92.50. The rate of return to the investor and the cost of preferred stock to the business is calculated as follows.
Dividend rate = 5.8% Par value = 100 Share price at issue = 92.50 Cost of preferred stock = (Dividend rate x Par value) / Share price at issue Cost of preferred stock = (5.8% x 100) / 92.50 = 6.27%
Unlike interest payments on debt finance the dividend payments on preferred stock are not deductible as an expense and therefore the tax rate has no impact on the cost of preferred stock.
New Issue Costs
The example above assumed that the investment cash received when issuing the preferred stock was the share price. However for new issues the business will have costs to pay. Usually these costs are expressed as a percentage of the share price, and the net investment received will be reduced. In these circumstances the cost of preferred stock formula is revised as follows.
If in the above example the issue costs were 5% then the cost of preferred equity is calculated as follows.
Dividend rate = 5.8% Par value = 100 Issue costs = 5% Share price = 92.50 Cost of preferred stock = (Dividend rate x Par value) / (Share price x (1 - Issue costs %)) Cost of preferred stock = (5.8% x 100) / (92.50 x (1 - 5%)) = 6.60%
The cost of preferred stock increases from 6.27% to 6.60% as a result of the issue costs.
Cost of Preferred Equity Finance and WACC
Preferred stock equity is only one method of funding a business, the others being common stock equity and debt finance. Most businesses use both equity and debt, and the proportion of each used results in a weighted average cost of capital (WACC) for the business. The cost of preferred equity financing is one component of the WACC calculation.
WACC Formula Example
Suppose a business is 35% funded by preferred stock equity, 40% funded by common stock equity and 25% funded by debt, and the cost of preferred stock is 8%, cost of common stock equity is 15%, the cost of debt is 6%, and the tax rate is 30%.
The WACC formula can be used to give the weighted average cost of capital as follows:
WACC = Cost of preferred stock x % Preferred stock + Cost of common stock x % Common stock + Cost of debt x (1- % Tax rate) x % Debt WACC = 8% x 35% + 15% x 40% + 6% x (1-30%) x 25% WACC = 9.85%
The WACC formula incorporating the cost of preferred equity shows that the weighted average cost of capital for the business is 9.85%.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.