Preferred stock is one special type of stock that provides constant dividends similar to interest income. The preferred stockholders have a special right to receive their stated dividends before the earnings can be distributed to the common stockholders.
In order to calculate the value of the preferred stock, we first need to know the cost of the preferred stock. In this article, we cover how to calculate the cost of preferred stock including the definition, formula, and example calculation.
So let’s get started!
What is the Cost of Preferred Stock?
Before jumping to the cost of preferred stock, let’s understand what is preferred stock dividend?
Preferred stock dividend is the dividend that provides to preferred stockholders before distributing to the common stockholders. It is typically a fixed dividend similar to the interest income.
Mostly, preferred stock dividends are stated as a dollar amount per year. For example, $5 preferred stock is expected to pay to the preferred stockholders at $5 per year.
On the other hand, the preferred stock dividends sometimes are stated as an annual percentage rate. Typically, this annual percentage rate represents the percentage of the par value or face value of the preferred stock. For example; 8% preferred stock with a face value of $1,000 would expect to pay an annual dividend of $80.
The cost of preferred stock is the ratio of the preferred stock dividend as compare to the net proceed from the sales of the preferred stock of the firm. The net proceeds represent the value of the preferred stock received minus any flotation costs of issuing the preferred stock.
How to Calculate the Cost of Preferred Stock?
In order to calculate the cost of preferred stock, we use the zero-growth model. This is because the preferred stock dividend is constant. Thus, the cost of preferred stock is calculated by dividing the annual preferred stock dividend by the net proceeds from the sales of preferred stock for the new issuance of preferred stock. For existing preferred stock, we use the current value of the preferred stock instead of net proceed.
Under the zero-growth model, we can write down the formula in order to calculate the cost of preferred stock as follows:
kp = D/P0
Where:
Kp = cost of preferred stock
D = preferred stock dividend
P0 = Value of preferred stock
The above formula is generally used for existing preferred stock; however, when there is new preferred stock, the flotation cost needs to take into account. Thus, we can rewrite the formula as follows:
kp = D/(P0 – F)
or kp = D/Np
Where:
P0 = the stock’s intrinsic value
F = Flotation cost
Np = Net proceeds from the sale of preferred stock (already taking out the flotation cost)
Example 1
ABC Corporation is considering issuing a 10% preferred stock that is expected to sell at a $50 par value per share. The market value of a similar stock is selling at $60. ABC Corporation must pay the flotation costs of 5% of the issuing price. What is the cost of preferred stock?
We can calculate the cost of preferred stock of this new issue by using the formula below:
kp = D/(P0 – F)
Where:
D = 50 × 10% = $5
P0 = $60
F = 60 × 5% = $3
Hence, kp = 5/(60 – 3) = 5/57
kp = 8.77%
Thus, the cost of new issue of preferred stock is 8.77%.
Example 2
ABC Corporation currently has 2,000,000 shares of preferred stock outstanding with an annual fixed dividend of 10% per share. Each preferred stock has a face value of $20. Currently, the market value is at $15. Calculate the cost of preferred stock.
As the preferred stocks are currently outstanding, thus, we can calculate the cost of preferred stock by using the below formula:
kp = D/P0
Where:
D = 20 × 10% = $2 (annual fixed dividend)
P0 = $15
Hence, kp = 2/15 = 13.3%
Thus, the cost of existing preferred stock is 13.3%
Limitation of Preferred Stock Valuation Model
There are some limitations of the preferred stock valuation model due to certain assumptions that have been used as follows:
- The preferred stock has indefinite life with no maturity date.
- We assume that the preferred stock is not convertible. If the preferred stock is convertible, this model cannot be used.
- The company needs to pay the preferred stock dividend on regular basis.
Conclusion
The calculation of the cost of preferred stock is straightforward. We commonly use the zero-growth model formula in order to calculate the cost of preferred stock both existing outstanding preferred stock and newly issued preferred stock.
