Cost of preferred stock

Definition

The cost of preferred stock refers to the return that a company must provide to its preferred shareholders, usually expressed as a percentage. This cost is an essential component of a firm's overall cost of capital and is calculated based on the dividends expected by investors, reflecting the risk associated with investing in the company's preferred equity. Understanding this cost helps firms assess their financing strategies and investment decisions.

5 Must Know Facts For Your Next Test

1. The cost of preferred stock is typically calculated using the formula: \( r_{ps} = \frac{D_{ps}}{P_0} \), where \( r_{ps} \) is the cost of preferred stock, \( D_{ps} \) is the annual dividend, and \( P_0 \) is the current price of the preferred shares.
2. Unlike common stock, preferred stock dividends are generally fixed and must be paid before any dividends can be distributed to common shareholders.
3. The cost of preferred stock is considered less risky than common equity but riskier than debt because preferred shareholders have a higher claim on assets in the event of liquidation than common shareholders.
4. Preferred stock does not usually come with voting rights, meaning that preferred shareholders have less influence over company decisions compared to common shareholders.
5. Changes in interest rates can affect the cost of preferred stock; if market rates rise, the price of existing preferred shares may fall, increasing the cost of issuing new preferred stock.

Review Questions

• How does the cost of preferred stock impact a company's decision-making regarding capital structure?
  • The cost of preferred stock significantly influences a company's capital structure decisions because it represents a fixed cost that must be met before any returns are provided to common equity holders. When assessing financing options, companies must compare the cost of preferred stock with other sources of capital like debt and equity. A lower cost of preferred stock relative to other financing methods may encourage a firm to issue more preferred shares to optimize its capital structure and manage overall costs effectively.
• Discuss the relationship between changes in market interest rates and the cost of preferred stock for a company.
  • Market interest rates have an inverse relationship with the price of existing preferred shares; when interest rates rise, the value of these shares typically falls. This decline can lead to an increased perceived cost when issuing new preferred shares because investors will demand higher dividends to compensate for their investment risk. Consequently, companies may face higher costs when raising funds through preferred stock issuance during periods of rising interest rates, affecting their overall financing strategies.
• Evaluate how the cost of preferred stock fits into the broader context of a firm's overall cost of capital and investment strategy.
  • The cost of preferred stock plays a crucial role in determining a firm's overall weighted average cost of capital (WACC), which combines costs from all sources of financing: debt, equity, and preferred stock. By accurately calculating this cost, firms can make informed investment decisions that align with their return expectations. A lower overall WACC enables companies to pursue more profitable projects that enhance shareholder value. Therefore, understanding and managing the cost of preferred stock is vital for optimizing financial performance and achieving long-term growth.

Related terms

Dividends: Payments made by a corporation to its shareholders, usually as a distribution of profits.

Cost of Equity:

The return required by equity investors for investing in a company's stock, representing the compensation for the risk of ownership.

Weighted Average Cost of Capital (WACC):

A calculation of a firm's cost of capital in which each category of capital is proportionately weighted, including equity, debt, and preferred stock.