Introductory Finance: Cost-of-Capital - Cost of Preferred Stock, Formula and Example

What This Is and Why It Matters

The cost of preferred stock is a critical concept in corporate finance, representing the return required by preferred stockholders. It's essential for valuing a company and making informed investment decisions. Miscalculating this can lead to poor financial planning and incorrect valuations, affecting both the company's financial health and investor confidence. For instance, underestimating the cost can result in overvaluing the company, leading to unrealistic expectations and potential financial distress.

Core Knowledge (What You Must Internalize)

• Preferred Stock: A type of stock that has a higher claim on assets and earnings than common stock. (Why this matters: It affects the company's capital structure and dividend policy.)
• Dividend per Share (D): The amount paid out to preferred stockholders. (Why this matters: It's a key component in calculating the cost of preferred stock.)
• Market Price per Share (P): The current trading price of the preferred stock. (Why this matters: It reflects the market's valuation of the stock.)
• Cost of Preferred Stock Formula: D / P (Why this matters: It's the fundamental formula for calculating the cost of preferred stock.)
• Dividend Yield: The ratio of the annual dividend to the market price per share. (Why this matters: It's another term for the cost of preferred stock.)

Step?by?Step Deep Dive

1. Identify the Dividend per Share (D)
2. Action: Determine the annual dividend paid to preferred stockholders.
3. Principle: Preferred stockholders receive a fixed dividend.
4. Example: If a company pays a $5 annual dividend on its preferred stock.

5. Pitfall: Confusing the dividend per share with the total dividend paid.

6. Determine the Market Price per Share (P)

7. Action: Find the current market price of the preferred stock.
8. Principle: The market price reflects the stock's value based on supply and demand.
9. Example: If the preferred stock is trading at $100 per share.

10. Pitfall: Using the par value instead of the market price.

11. Calculate the Cost of Preferred Stock

12. Action: Use the formula D / P.
13. Principle: The cost of preferred stock is the dividend yield.
14. Example: D / P = $5 / $100 = 0.05 or 5%.
15. Pitfall: Incorrectly interpreting the result as a dollar amount instead of a percentage.

How Experts Think About This Topic

Experts view the cost of preferred stock as a benchmark for evaluating the company's cost of capital. They understand that it represents the minimum return required by preferred stockholders and use it to make strategic financial decisions. Instead of seeing it as a standalone figure, they integrate it into the overall capital structure analysis.

Common Mistakes (Even Smart People Make)

• The mistake: Using the par value instead of the market price.
• Why it's wrong: Par value is often not the current market value.
• How to avoid: Always use the current market price.

• Exam trap: Questions that provide par value but not market price.

• The mistake: Confusing the total dividend with the dividend per share.

• Why it's wrong: The total dividend includes all preferred stock, not just one share.
• How to avoid: Verify that you are using the dividend per share.

• Exam trap: Questions that give the total dividend paid.

• The mistake: Interpreting the cost as a dollar amount.

• Why it's wrong: The cost is a percentage, representing the dividend yield.
• How to avoid: Remember that the formula result is a percentage.
• Exam trap: Questions that ask for the cost in dollar terms.

Practice with Real Scenarios

Scenario: A company pays an annual dividend of $6 per share on its preferred stock, which is currently trading at $120 per share. Question: What is the cost of the preferred stock? Solution:
1. Identify the dividend per share: $6.
2. Determine the market price per share: $120.
3. Calculate the cost: D / P = $6 / $120 = 0.05 or 5%. Answer: 5%. Why it works: The cost of preferred stock is the dividend yield, which is the ratio of the dividend to the market price.

Scenario: A company's preferred stock has a par value of $100 and pays an annual dividend of $4 per share. The stock is trading at $80 per share. Question: What is the cost of the preferred stock? Solution:
1. Identify the dividend per share: $4.
2. Determine the market price per share: $80.
3. Calculate the cost: D / P = $4 / $80 = 0.05 or 5%. Answer: 5%. Why it works: The market price, not the par value, is used to calculate the cost.

Quick Reference Card

• Core rule: The cost of preferred stock is the dividend yield.
• Key formula: D / P.
• Critical facts:
• Use the market price per share.
• The result is a percentage.
• Preferred stock has a fixed dividend.
• Dangerous pitfall: Using par value instead of market price.
• Mnemonic: "Divide D by P for the cost, it's easy as can be."

If You're Stuck (Exam or Real Life)

• Check: The market price and dividend per share.
• Reason: From the basic principle that the cost is the dividend yield.
• Estimate: By rounding the market price and dividend to simplify calculations.
• Find the answer: By referring to financial statements or market data.

Related Topics

• Cost of Equity: Understand how it differs from the cost of preferred stock and its impact on the company's capital structure.
• Weighted Average Cost of Capital (WACC): Learn how the cost of preferred stock fits into the overall cost of capital for a company.