Publicly-held companies sell shares of stock to raise money for use in financing operations, funding business improvements and supporting various other projects. They typically offer two different types of stock, common and preferred, and each type has its own characteristics.
Companies must examine the cost of preferred stock, or any source of funds because it represents the cost of raising money. For example, a bank loan might cost 9 percent interest, while borrowing money in the form of bonds sold to investors could cost 5 percent.
Raising money by selling preferred stock could cost the company 10 percent, paid in the form of dividends to shareholders. Various factors drive the actual cost of preferred stock.
Calculating the Cost of Preferred Stock
You can use the following formula to calculate the cost of preferred stock:
Cost of Preferred Stock = Preferred stock dividend / Preferred stock price
For the calculation inputs, use a preferred stock price that reflects the current market value, and use the preferred dividend on an annual basis. You can also factor in the projected growth rate of the company's dividends with the following formula:
Cost of Preferred Stock = Preferred stock dividend at year 1 / Preferred stock price + dividend growth rate
The cost of preferred stock will likely be higher than the cost of debt, as debt usually represents the least-risky component of a company's cost of capital. If a firm uses preferred stock as a source of financing, then it should include the cost of the preferred stock, with dividends, in its weighted average cost of capital formula.
As a side note, most preferred stock is held by other companies instead of individuals. If a company holds preferred stock, it can exclude 70 percent of the dividends it receives from the preferred from taxation, so this actually increases the after-tax return of the preferred shares. After the Tax Reform Act of 1986, individuals no longer received this benefit, starting with the 1987 tax year.
Preferred Stock Characteristics
Preferred stock offers certain advantages for investors. In certain ways, it outranks common stock, meaning that if a company has limited funds to pay out as dividends, preferred shareholders get paid before common shareholders.
Likewise, if a company has to liquidate its assets, bondholders get paid first, then preferred shareholders, then common shareholders. However, common shareholders get voting rights, while preferred shareholders do not. Preferred dividends tend to be fixed, and more stable than the fluctuating dividends paid on common stock.
Companies have no obligation to pay dividends to preferred stockholders. However, they usually do pay them, because not paying dividends can send out a negative financial signal to investors and the market.
The Overall Cost of Capital
A company's weighted average cost of capital represents the average interest rate a company must pay to finance its operations, asset purchases or other needs. It also signifies the minimum average rate of return the company must earn on its current assets to satisfy its shareholders or owners, investors, and creditors.
The company's weighted average cost of capital derives from the firm's capital structure and captures the cost of all of the firm's sources of financing; for example, a firm may use both debt financing and equity financing. The cost of capital represents the amount a firm pays to finance its operations, without being specific about the composition of the capital structure, whether debt, common or preferred equity.
The cost of preferred stock would be factored into the company's weighted average cost of capital calculation, along with any funds received from common stock or debt issues.
Some small business firms use strictly debt financing for their operations. Other small startups use only equity financing, particularly if they have received funding from equity investors such as venture capitalists. As these small firms grow, they will likely begin to use a combination of debt and equity financing over time.