The Cost of Preferred Stock
Preferred stock is an equity security with properties of both an equity and a debt instrument. It is generally considered a hybrid instrument. Preferred stock represents some degree of ownership in a company, but usually doesn't come with the same voting rights. In the event of liquidation, preferred shareholders are paid off before the common shareholder, but after debt holders. Preferred stock may also be callable or convertible, meaning that the company has the option to purchase the shares from shareholders at anytime for any reason - usually for a premium - or convert the shares to common stock. Similar to bonds, preferred stocks are rated by the major credit rating companies. Some people consider preferred stock to be more like debt than equity.
Contribution To Cost of Capital
Because preferred stock carries a differing amount of risk than other types of securities, we must calculate its asset specific cost of capital to work into our overall weighted average cost of capital. Similar to debt, this can be a relatively simple process since we can observe values needed as inputs in the market. With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common stock, which has variable dividends that are never guaranteed. If preferred dividend is known and fixed, we can use the following equation to calculate the cost of capital for preferred stock .
Cost of Preferred Stock
The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the growth rate.
This tells us that the cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the expected growth rate. The dividend is usually specified as a percentage of the par value or as a fixed amount. Sometimes, dividends on preferred shares may be negotiated as floating - they may change according to a benchmark interest rate index.
Example Equation
$10 divided by $100, plus 3%.