Cost of Preferred Stock

Definition

The cost of preferred stock refers to the rate of return required by investors for holding a company's preferred shares. This cost is a vital component of a company's overall cost of capital and reflects the risk perceived by investors, as preferred stockholders have a higher claim on assets than common shareholders but lower than debt holders. Understanding this cost is essential for companies when making financing decisions and evaluating investment opportunities, as it impacts the overall capital structure and financial health.

5 Must Know Facts For Your Next Test

1. The cost of preferred stock is calculated using the formula: Cost of Preferred Stock = Dividend / Net Issuance Price.
2. Preferred stock dividends are usually fixed, making the cost of preferred stock less volatile compared to common equity.
3. Unlike debt, preferred stock dividends are not tax-deductible, which can make them more expensive for companies in terms of after-tax cost of capital.
4. The issuance of preferred stock can be an attractive option for companies seeking to raise capital without diluting common equity ownership.
5. The cost of preferred stock is considered a component in calculating the WACC, which helps in assessing investment decisions and capital budgeting.

Review Questions

• How does the cost of preferred stock impact a company's overall cost of capital and investment decisions?
  • The cost of preferred stock directly influences a company's overall cost of capital as it represents a required return that must be met when evaluating investment opportunities. When determining the Weighted Average Cost of Capital (WACC), the cost of preferred stock is factored in along with other components like debt and equity. A higher cost of preferred stock can lead to increased WACC, making some investments less attractive or feasible, while also affecting how companies choose to finance their operations.
• Discuss how the fixed nature of preferred stock dividends affects its cost compared to common equity.
  • Preferred stock dividends are generally fixed, which means that the payments to preferred shareholders do not fluctuate with company performance like common equity dividends might. This fixed nature makes the cost of preferred stock less volatile compared to common equity, providing a more stable expectation for returns. Consequently, when companies evaluate financing options, they may find that the predictable costs associated with preferred stock can be advantageous in managing cash flow and financial planning.
• Evaluate the strategic implications of choosing to issue preferred stock over debt or common equity in terms of cost and control.
  • When a company considers issuing preferred stock instead of debt or common equity, it must weigh several strategic implications. While preferred stock can be less risky than debt—since dividends do not have to be paid if cash flow is tight—it does not carry voting rights, thus preserving control for existing shareholders. However, the lack of tax deductibility for preferred dividends compared to interest payments on debt can make it a more expensive form of financing in terms of after-tax costs. Companies must carefully assess their capital structure goals and market conditions to determine the best option for maintaining flexibility while minimizing costs.

Related terms

Dividend: A portion of a company's earnings distributed to shareholders, typically paid on a regular basis, and an important consideration for preferred stockholders.

Cost of Equity:

The return required by equity investors for investing in a company's common stock, reflecting the risk associated with holding equity.

Weighted Average Cost of Capital (WACC):

The average rate that a company is expected to pay to finance its assets, taking into account the proportionate weight of each component of its capital structure.