Intro to Finance: Cost of Capital Cost of Preferred Stock Rp Dp Pp

What This Is

The cost of preferred stock (Rp) is the return investors demand for holding preferred stock. It's an essential concept in finance, as it helps investors and companies evaluate the attractiveness of preferred stock investments. For example, let's consider Apple's 5% preferred stock with a face value of $1,000. If the market price of the preferred stock is $950, the cost of preferred stock (Rp) can be calculated as follows: Rp = Dp / Pp = 5% / $950.

Key Formulas & Symbols

• Rp = Dp / Pp where Rp = cost of preferred stock, Dp = dividend per share, Pp = market price per share.
• Dp = Face Value × Dividend Rate where Dp = dividend per share, Face Value = par value, Dividend Rate = annual dividend rate.
• Pp = Market Value where Pp = market price per share, Market Value = current market price.
• Dividend Rate = Annual Dividend / Face Value where Dividend Rate = annual dividend rate, Annual Dividend = annual dividend payment, Face Value = par value.
• Market Value = Face Value × (1 + (1 - Tax Rate) × Dividend Rate) where Market Value = current market price, Face Value = par value, Tax Rate = corporate tax rate, Dividend Rate = annual dividend rate.

Step-by-Step Calculation

1. Determine the annual dividend payment (Dp) by multiplying the face value by the dividend rate: Dp = Face Value × Dividend Rate.
2. Calculate the market price per share (Pp) using the formula: Pp = Market Value.
3. Plug in the values into the cost of preferred stock formula: Rp = Dp / Pp.
4. Verify the calculation by checking if the market price per share (Pp) is equal to the market value.

Common Mistakes

• Mistake: Using the face value instead of the market value for the cost of preferred stock calculation.
• Correction: Always use the market value, as it reflects the current market price of the preferred stock.
• Mistake: Forgetting to consider the tax implications on the market value.
• Correction: Include the tax implications by using the formula: Market Value = Face Value × (1 + (1 - Tax Rate) × Dividend Rate).
• Mistake: Assuming the dividend rate is the same as the cost of preferred stock.
• Correction: The dividend rate is the annual dividend payment divided by the face value, while the cost of preferred stock is the dividend per share divided by the market price per share.

Exam / CFA Tips

• Tip: Be prepared to calculate the cost of preferred stock using different dividend rates and market prices.
• Tip: Understand the tax implications on the market value and how it affects the cost of preferred stock.
• Tip: Distinguish between the dividend rate and the cost of preferred stock.

Quick Practice Problem

Apple's 5% preferred stock has a face value of $1,000 and a market price of $950. What is the cost of preferred stock (Rp)?

Answer: Rp = 5% / $950 = 0.0052 or 0.52%.

Explanation: The cost of preferred stock is calculated by dividing the annual dividend payment by the market price per share.

Last-Minute Cram Sheet

• ⚠️ The cost of preferred stock (Rp) is not the same as the dividend rate.
• ⚠️ Always use the market value for the cost of preferred stock calculation.
• ⚠️ Include tax implications when calculating the market value.
• ⚠️ The dividend rate is the annual dividend payment divided by the face value.
• ⚠️ The cost of preferred stock is the dividend per share divided by the market price per share.
• ⚠️ The market value is equal to the face value times (1 + (1 - Tax Rate) × Dividend Rate).
• ⚠️ The cost of preferred stock is a key component in evaluating the attractiveness of preferred stock investments.
• ⚠️ The cost of preferred stock is used in conjunction with other metrics, such as the cost of debt and the cost of equity.
• ⚠️ The cost of preferred stock is an essential concept in finance, particularly in corporate finance and investments.