What is the cost of preferred stock?

What is Preferred Stock?

Preferred stock is used to fund expansion projects or improvements that firms seek to engage in. Like all other equity capital forms, selling preferred stock helps companies to raise funds.

Preferred stock does not dilute the ownership stake of common shareholders, as preferred shares don’t hold the same voting rights that common shares do.

What is the cost of preferred stock?

The price of the preferred stock is the price the company pays in return for the income it gets from the issuance and sale of shares. It is the money a company pays in a year divided by the lump-sum amount they receive by issuing the shares.

The management of companies uses this metric to find ways of investment that are most cost-effective and cost-efficient. Companies normally use several instruments, such as stock and debts to finance their operations.

By dividing the annual preferred dividends by the market price per share, the price of preferred stock is calculated. Once the rate is obtained, it can be used for other calculations. The preferred stock is also used to calculate the weighted average cost of capital (WACC).

Here's the formula to calculate the cost of preferred stock −

$$\mathrm{𝑅_{𝑝} =\frac{𝐷\:(dividend)}{𝑃_{0 }\:(price)}}$$

For example − let's suppose a company has preferred stock that has an annual dividend of INR 300. If the current share price is INR 2500, what is the cost of preferred stock?

In this case, the cost of preferred stock,

$$\mathrm{𝑅_{𝑝} =\frac{𝐷}{𝑃_{0}}=\frac{300}{2500}= 12 \%}$$

Usually, the management of a company decides the investment options and chooses the best option of issuing the shares. As preferred shareholders are paid dividends each year, the management of the company must include it in the price of raising capital with preferred stock.

The cost of preferred stock varies like any other stock price once it has been issued. The price of the stock would be subject to supply and demand forces in the market. Preferred stock is seen as more valuable than common stock. Preferred stock has a greater likelihood of paying a good dividend and offers a greater amount of security if the company stops its business.

Preferred vs Common Stock vs Debt

Preferred stock and common equity are different in several ways. One of the distinctions is that preferred shareholders are the first to get the dividend payments. In the event of liquidation, preferred shareholders are considered first after bondholders, but before common equity holders.

Because of the general nature of preferred stock dividends, it is also sometimes called perpetuity. For the given reason, the cost of the preferred stock formula and the perpetuity formula is closely similar.