Cost of Debt, Preferred Stock, and Common Stock

Cost of Preferred Stock

Preferred stock dividends are not tax deductible to the company who issues them. Preferred stock dividends are paid out of after-tax cash flows so there is no tax adjustment for the issuing company.

When investors buy preferred stock they expect to earn a certain return. The return they expect to earn on preferred stock is denoted $r_{ps}$ .

$D_{ps}$ is the dividend from preferred stock, $P_{ps}$ is the price of preferred stock.

Worked Example: Falcons Footwear

Falcons Footwear has 2 million shares of preferred stock selling for $85/share. Its annual dividend is $7.50. What's the $r_{ps}$ ?

Typically the cost of preferred stock is higher than the after-tax cost of debt. This is because of both the tax deductibility of interest and the fact that preferred stock is riskier than debt.

Key Takeaways

Preferred stock is a hybrid security - it's both debt and equity.
Preferred stock return is calculated as its dividend divided by its price.

Exercises

Calculate the component cost of preferred stock given the following: Company A has $10 million in preferred stock selling for $100 each and pays a dividend of $7.80. What's the $r_{ps}$ ?
Why is there no tax-adjustment made to our calculation of preferred stock?

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