Estimating the Cost of Preferred Stock

This lesson is part 6 of 12 in the course Cost of Capital

Cost of preferred stock is the cost that the company has committed to pay to the preferred stockholders in the form of preferred dividends.

For a plain vanilla preferred stock (No convertibility or callable features), the cost is calculated as follows:

Cost of preferred stock, $r_{p}=\frac{D_{P}}{P_{P}}$
Where,

D = Preferred stock dividend per share

P = Current price of each preferred stock

Example:

A company has certain preferred stock outstanding on which it pays a fixed dividend of $5 per share. The current price of this stock is $80.

The cost of preferred stock = $5/$80 = 6.25%

The preferred stock may have additional features, which affects its yield and the cost. For example, call options, convertible into common stock, cumulative dividends, adjustable-rate dividends, etc. While estimating the cost of the stock, the analyst will have to adjust the cost based on the impact of these features on the yield of the stock issue.

The analyst will also have to consider the changes in the cost of preferred stock for future issues. If a company has an existing preferred stock issue for which the dividend of 6%, but for a newly planned preferred stock issue requires the dividend to be 7%, then the cost of preferred stock will be considered based on the current terms (7%) rather than the past terms.

Also, unlike the interest on debt, the dividend paid on preferred stock is non tax-deductible, so the analyst cannot adjust the cost of preferred stock based on the marginal tax rate.