Cost of Preferred Stock
The annual payment a company makes for issuing preferred stock
What Is the Cost Of Preferred Stock?
The cost of preferred stock is the annual payment a company makes for issuing preferred stock. It is the annual dividend payment on preferred equity divided by the market price per share of the preferred stock.
It is a component of calculating the company's WACC, which has applications regarding its budgeting and project acceptance decisions.
Preferred stock is legally regarded as equity but acts more like a bond. Therefore, it has characteristics like bonds as opposed to common equity. For instance, its stockholders do not have the right to vote and are paid before common stockholders in the event of liquidation.
There are three types of preferred stock:
- Cumulative stock allows the company to withhold dividends in times of economic downturn and pay them off once the firm can.
- Convertible shares give the investor the option to convert them to common stock. The conversion is typically at the discretion of the shareholder holding the convertible shares, and it can also be done through board members' votes or automatically on a predetermined date.
- Redeemable shares allow companies to call back their stock after a certain date, typically if interest rates drop. However, this type often has a higher return for the investor because companies usually offer higher dividend rates to compensate for the potential callback.
Not all companies choose to have these securities as a part of their capital structure. Some companies prefer more debt, and others prefer more common equity. A firm's capital structure depends on which ratio adds the most value to it.
Key Takeaways
- The cost of preferred stock is the annual payment a company makes for issuing preferred stock.
- It is determined by dividing the annual dividend per share by the current price per share. The resulting percentage represents the yield on the preferred stock.
- This metric is crucial for companies in determining their Weighted Average Cost of Capital (WACC).
Understanding the Cost of Preferred Stock
The cost of preferred stock is the price preferred stock pays in return for the annual income it provides in the form of a dividend to its preferred equity investors expressed as a percentage. In other words, it is the dividend yield on preferred equity securities issued.
Companies can raise funds for future projects in a couple of common ways:
- Retaining earnings and issuing stocks
- Bonds
- Preferred stocks
The cost of preferred stock is used by managers when determining which method of raising capital is the most effective. Managers use a formula to calculate the cost of preferred equity to compare it with the rate of other financing options.
Likewise, it is an important metric because companies use it to determine their accurate Weighted Average Cost of Capital (WACC), which has numerous applications.
The formula for the cost of preferred stock is similar to the perpetuity formula due to its unamortized nature.
The Cost of Preferred Stock Formula
The cost of preferred equity is calculated by dividing its dividend per share by its current price, as per the following formula:
Rp = Dividend per share/ Current price
or
Rp = D/ P0
For instance, a company has an annual dividend of $4, and its current price per preferred share is $30. Therefore, we can Rp by using the formula as follows:
Rp= 4/ 30= 0.13
The Rp is equal to 0.13 or 13%. Therefore, the yield on the company’s preferred stock is 13%. Managers will use this rate to calculate the WACC and compare it to the rates of other financing options to determine the extent to which it will fund their operations.
What is Preferred Stock?
Preferred stock is a form of equity that firms issue to raise funds. Legally, it is regarded as equity, but its characteristics are similar to bonds. Preferred equity owners get paid before common stock owners, and the dividend rates remain unchanged.
Therefore, the dividend investors receive does not increase as the company expands, as it does with common equity dividends. Additionally, the company is obliged to pay a fixed dividend even in periods of loss.
These securities can be attractive for investors who dislike risk or want to diversify their portfolios with more stable securities.
Therefore, the risk and return are lower for preferred stocks compared to common stocks. Additionally, the seniority structure forbids the company from legally issuing dividends to common stockholders before preferred equity holders.
Note
Preferred equity owners do not have voting rights, unlike common stockholders. Therefore, they do not have any decision-making power in the company.
Most companies choose to keep their preferred equity financing lower than common equity and debt financing because the latter is more advantageous. For instance, companies commonly use debt financing to pay fewer taxes because the interest on debt is tax-deductible.
The effect of preferred stock on a company’s WACC can vary, and it needs to be acknowledged for a comprehensive and accurate WACC calculation.
However, all debt instruments have a higher claim than equity in terms of seniority, as the company is obligated to pay off debt before rewarding shareholders with dividends in the event of liquidation.
As previously mentioned, this type of stock is commonly known as “perpetuity” due to the nature of their payments being constant with no maturity date. That is why the formula for this metric closely mimics the perpetuity formula.
Regardless of its fixed monthly payments to investors, the preferred stock price is subject to market changes.
Sometimes, preferred equity is issued with additional options that can impact its financing cost. The features include all kinds of call options, such as conversion features, cumulative paid-in-kind dividends, etc. These changes may need to be considered.
Types of Preferred Stock
There are several types of preferred equity stock, and they all have different characteristics. These types include:
1. Convertible
This type of stock can be converted into common stock in the future. When it gets converted depends on the preset conditions of the stock.
An individual investor can also decide to convert. However, it would only be profitable to exercise this right if the price of the common stock were more than the net present value of the preferred stocks.
Likewise, the stock could have a predetermined conversion date, or the company’s board of directors may be able to vote for a conversion.
2. Cumulative
This type allows companies to delay dividend payments in times of downturn. However, they are required to pay back all the missed dividends when they are financially able to and must do so before distributing any dividends to common stockholders.
3. Redeemable
This type gives the company the option to redeem the stock at any given time after a certain preset date, which is usually after a few years.
The option best describes the price the company will pay for the stock. This type of stock is subject to redemption risk and has a higher dividend to compensate for it.
Companies can use this option when interest rates drop. They could issue new preferred stocks at a lower rate and distribute smaller dividends instead. If a company chooses to do so, it means less profit for the investor. This is why this option has a higher risk.
How is the Cost of Preferred Stock related to WACC?
As previously mentioned, this metric calculates a company’s WACC. The formula for WACC is estimated by multiplying each component’s weight by the component cost and summing up the products.
It takes into consideration the three main financing methods as well as the flotation rate. Each financing method has its own risk and return profile and, therefore, its own rate of return required by investors.
The WACC is essentially the average rate of return the firm should earn on its investments of average risk to satisfy all providers of capital.
Its applications include the discount rate for computing Net Present Value (NPV) and the hurdle rate to compare with the Internal Rate of Return (IRR).
Both of these metrics, along with other financial metrics, are used by companies in their capital budgeting decision-making process to assess the profitability of expansion projects and to select the most viable ones.
WACC is a key metric for companies, and it cannot be calculated accurately without the cost of preferred equity.
Cost Of Preferred Stock FAQs
It is the yield the company receives on its preferred equity. Its role is to give an accurate estimate of the WACC, which helps the firm select future projects to expand further and bring in more profits.
Preferred equity prices tend to mimic bond prices more than common stock prices. Like with bonds, the relationship between price and interest rate is inverse. Therefore, when interest rates rise, the price falls, and vice versa.
WACC would not be accurate if the company issued preferred equity and excluded it from its WACC calculations. Therefore, it is important for businesses to have exact numbers.
Preferred stocks can be bought like common stocks. First, you need to access the capital markets through a brokerage account.
You can then search for these securities, but they might not be listed together with common stock. There is a chance that they are on a different section of the website. However, keep in mind that not all companies issue these securities.
The answer depends on the investor in question. If an investor is more risk averse, they might be more comfortable with preferred shares over common shares due to their fixed dividend.
Likewise, investors may consider preferred shares for short-term investments or if they cannot hold common stock long enough to overcome dips in the share price.
However, common stocks can be a better option for investors willing to take the risk and possess larger funds. Through common stock, investors can see the companies they believe in growing along with their dividends and equity value.
There are multiple courses on the WSO website that can teach you how to do financial valuations used by firms on a daily basis.
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