What is the Cost of Preferred Stock?

//What is the Cost of Preferred Stock?
What is the Cost of Preferred Stock? 2017-10-02T07:32:58+00:00

Definition: The cost of preferred stock is the rate that the company must pay investors in order to persuade them into investing in preferred shares of the company. In other words, it’s the rate or return investors expect to receive based on the market price of the stock and the annual dividend amount.

What Does Cost of Preferred Stock Mean?

What is the definition of cost of preferred stock? Preferred stock is commonly issued to fund new developments and projects a firm wants to complete in the future. This allows the company to raise capital and dilute the current ownership percentages of the common shareholders because preferred shares don’t have voting rights. Preferred stock is also a more flexible option to a typical bond.

Management often uses this metric to determine what way of raising capital is most effective and efficient. Corporations can issue debt, common shares, preferred shares, and a number of different instruments in order to raise funds for expansions or continuing operations.

It’s management’s job to analyze the costs all of these options and pick the best one. Since preferred shareholders are entitled to dividends each year, management must include this in the price of raising capital with preferred stock.

They calculate the cost of preferred stock formula by dividing the annual preferred dividend by the market price per share. Once they have the rate, they can compare it to other financing options.

Let’s look at an example.

Example

Let’s assume Best Electronics already has preferred shares on the market that are currently trading for $250 per share. Best wants to wants to open 50 more locations across the country, but it needs the capital to fund this and cannot issue any more common shares. Thus, the Best management team has to compare the cost of debt to preferred shares.

Best already knows it can take out a 5% loan from the bank, so the management needs to figure out how much the preferred option will cost. Best would issue $500 par value non-cumulative shares that pay a dividend rate of 10 percent.

Using the equation above, Best would calculate its costs to be 20% = ($50 annual dividend / $250 market price per share)

Since the company can borrow the funds at 5%, it wouldn’t make sense to issue preferred shares at 20 percent. Thus, the management chooses to fund the expansion with debt.

Summary Definition

Define Cost of Preferred Stock: Cost of preferred shares means the percentage investors require in order to invest in this class of stock.