Question

How to calculate the component cost of preferred stocks for a firm? Is cost of preferred stock in a company greater than its component cost of debt, why?

Answer 1

Preferred stock generally offers a fixed dividend, the dividend amount does not fluctuate based on earnings. The term preferred also implies that shareholders have a right to receive their specified dividend before common stockholders are paid any dividends.

If a company pays a fixed dividend at the end of each year, the valuation is determined using the zero dividend growth model used for common stock.

V_p= D/K

D is the cash dividend

K is the discount rate

The cost associated with preferred stock is a function of the dividend paid to shareholders and a flotation coat.

k_p = D_p/P_p - F

k_{p = cost of preferred stock}

D_{p = preferred stock dividend}

P_{p = the current price per share}

F = floting cost per share

The cost of preferred stock is greater than the cost of debt because we pay interest on debt and interest is an expense that can be used to deduct tax liability. Preferred stock dividends are not tax-deductible, they represent an outflow of after-tax funds. So, the after-tax cost of debt is lower than preferred stock.