Cost of Preferred Stock
The term cost of preferred stock refers to a calculation that allows the investor-analyst to understand how expensive it is for a company to issue preferred stock. The cost of preferred stock is also one of three metrics used to calculate a company’s cost of capital
Cost of Preferred Stock = Interest Expense on Preferred / Total Preferred Stock
- The interest expense in this metric only includes the expense associated with payments on preferred stock (typically in the form of dividends), not interest expense on debt. Interest paid on preferred stock is not tax deductible, so it is not adjusted for income taxes. (A company’s interest expense on debt is multiplied by 1 – the company’s incremental tax rate to account its tax deductibility.)
- The denominator of this calculation includes the total value of all preferred shares issued to the public.
Market performance measures allow the investor-analyst to understand the company’s ability to achieve their high level business profitability objectives. This is usually assessed by examining metrics such as insider transactions, capture ratios, enterprise value, capitalization rates and price to earnings ratios. Market performance metrics provide analysts with a way to determine if a company is going to successfully execute their business plan. One of the ways to determine how expensive it is to provide a return to holders of preferred stock is by calculating the cost of preferred stock.
While the investor-analyst may be interested in a company’s cost to provide holders of preferred shares with their dividends, cost of preferred stock is also one of three components used when calculating a company’s cost of capital. This later measure is important to understand, since new investment decisions should produce results that generate returns greater than the company’s cost of capital. The cost of preferred stock is calculated by dividing the interest paid on preferred shares (a dividend payment) by the total value of preferred shares held by investors. Multiplying this value by 100 allows the analyst to express the number as a percentage.
The CFO of Company ABC is concerned the return on new investments are not being challenged and may be lower than the company’s cost of capital. Much to her surprise, the company hadn’t even calculated its cost of capital in recent years. After calculating the company’s cost of debt (3.15%), she asked her analytical team to begin the process of calculating the company’s cost of preferred stock. The team pulled information from both the company’s balance sheet (preferred stock will be found as part of capital stock, which is reported in the stockholders’ equity section of the balance sheet) as well as information on the payment of preferred dividends from its income statement. The information below is what they found:
- Last year’s preferred dividends amounted to $468,000, while the total value of preferred stock was reported at $16,125,000.
From this information, the cost of preferred stock was calculated as:
= $468,000 / $16,125,000, or 0.0290
The team has now found the cost of debt to be 3.15% and the cost of preferred stock to be 2.90%, the final step to determine the company’s cost of capital is to calculate the cost of common stock.