Cost of preferred stock

What is cost of preferred stock ?

Cost of preferred stock is the rate of return that an investor investing in the preferred stock of a company expects from his investment. It is calculated by dividing the Annual preference dividend payment on the stock by the market price of the preferred stock.

This is a basic formula used for calculation of cost of preferred stock. It based on the following assumptions :

1.The company pays a fixed rate of dividend regularly.

2.The preferred stock issued does not have a fixed maturity date.

3.The stock issued is no convertible into equity shares at a later date.


How would you calculate the cost of preferred stock ?

The formula for calculating the cost of preferred stock without floatation cost is

= Dividend Per Share / Market price per share

Example 1 :

Cash Rich Co.  has preferred stock trading in the market at $ 25 per share. The next preferred dividend of $ 5 is due in one year. What is Cash Rich co.’s cost of capital for preferred stock?

Solution:

The formula for calculating the cost of preferred stock is

= Dividend Per Share / Market price per share


As per the information provided

Dividend Per Share = $ 5 per share ;  Market price per share  = $ 25 per share  ;


Applying the above values in the formula we have the cost of preferred stock as

= $ 5 / $ 25

= 0.20  = 20 %


How would you calculate Cost of preferred stock with Floatation cost ?

It is calculated by dividing the Annual preference dividend payment on the stock by the Market price of the stock adjusted for floatation cost. The floatation cost is deducted from the Market price of the stock.

The formula for calculating the cost of preferred stock with floatation cost involved

= Dividend Per Share / ( Market price per share * ( 1 – Floatation cost ) )

 

Example 2 :

Cash Rich Co. has recently issued 10 % preferred stock, with a par value of $ 100 and trading at $ 90 in the market. The floatation cost on the stock is 5 %. Calculate the cost of capital of the preferred stock.

Solution:

The formula for calculating the cost of preferred stock when floatation cost is involved is

= Dividend Per Share / ( Market price per share * ( 1 – Floatation cost ) )


Dividend Per Share = Par value per share * Dividend rate = $ 100 * 10 %  = $ 10 per share ; 

Market price per share   = $ 90 per share  ;   Floatation cost = 5 % = 0.05


Applying the above values in the formula we have the cost of capital of preferred stock as

= 10 / ( 90 * ( 1 – 0.05) ) 

= 10 / ( 90 * 0.95 )

= 10 / 85.50    = 0.116959

= 11.6959 %   = 11.70 % ( when rounded off to two decimal places )


How would you calculate cost of preferred stock with growth ?

It is calculated by dividing the Annual preference dividend payment on the stock by the Market price of the stock. The growth rate is then added to the Market price of the stock.

= ( D1 / P ) + g

= ( Dividend Per Share / Market price per share ) + Growth rate 

 

Example 3 :

Cash Rich Co. has recently issued 10 % preferred stock, with a par value of $ 100 and trading at $ 80 in the market. The growth rate of the stock is 5 %. Calculate the cost of capital of the preferred stock.

Solution:

The formula for calculating the cost of preferred stock when floatation cost is involved is

= ( D1 / P ) + g

= ( Dividend Per Share /  Market price per share ) + Growth rate 

Dividend Per Share = Par value per share * Dividend rate  = $ 100 * 10 %  = $ 10 per share ; 

Market price per share = $ 80 per share  ;   Growth rate = 5 % = 0.05   ;


Applying the above values in the formula we have the cost of capital of preferred stock as

= ( 10 / 80 ) + 0.05

= 0.1250 + 0.05 = 0.1750

= 11.50 % ( when rounded off to two decimal places )


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