Cost of preferred stock

Definition

The cost of preferred stock refers to the return that a company is obligated to pay to its preferred shareholders, typically expressed as a percentage. This cost is a crucial component in determining a company's overall cost of capital, as it influences how firms assess the profitability of investment opportunities and the mix of financing options available to them. It’s important for understanding how preferred stock fits into the larger financial framework, especially when calculating the weighted average cost of capital.

5 Must Know Facts For Your Next Test

1. The cost of preferred stock is calculated using the formula: $$Cost_{preferred} = rac{D_p}{P_0}$$, where $$D_p$$ is the annual dividend and $$P_0$$ is the current market price of the preferred stock.
2. Unlike common stockholders, preferred shareholders typically do not have voting rights, but they have a higher claim on assets and earnings than common shareholders.
3. Preferred stock dividends are usually fixed and must be paid before any dividends can be distributed to common shareholders, making their cost critical for financial planning.
4. In times of financial distress, companies may suspend preferred stock dividends without triggering bankruptcy, but this can adversely affect their reputation and stock prices.
5. Understanding the cost of preferred stock helps companies optimize their capital structure by balancing debt and equity financing to minimize overall costs.

Review Questions

• How does the cost of preferred stock impact a company's decision-making when evaluating investment opportunities?
  • The cost of preferred stock plays a significant role in a company's decision-making process as it represents the expected return required by preferred shareholders. When evaluating investment opportunities, firms must ensure that the returns exceed this cost to create value for shareholders. If an investment does not generate sufficient returns above the cost of preferred stock, it could lead to suboptimal financial performance and reduced shareholder satisfaction.
• Discuss how the cost of preferred stock fits into a company's overall capital structure and its effect on WACC.
  • The cost of preferred stock is an integral part of a company's capital structure as it represents one source of financing alongside debt and equity. When calculating the weighted average cost of capital (WACC), this cost must be included as it affects the overall average return required by all investors. A higher cost of preferred stock can increase WACC, potentially making new projects less attractive if they do not meet or exceed this average cost.
• Evaluate the implications of a rising cost of preferred stock on a company's financial strategy and its ability to attract capital.
  • A rising cost of preferred stock can significantly impact a company's financial strategy as it may signal higher perceived risk by investors or changes in market conditions. This increase can lead to adjustments in dividend policies or funding strategies, forcing companies to reconsider issuing new preferred shares or even replacing them with less expensive forms of financing. As capital becomes more costly, attracting new investment could become more challenging, which may hinder growth opportunities and require firms to focus on maintaining strong operational performance to reassure investors.

Related terms

dividend yield: The dividend yield is the annual dividend payment expressed as a percentage of the stock's current market price, providing insight into the income generated by an investment in preferred stock.

capital structure: Capital structure refers to the way a company finances its overall operations and growth through various sources of funds, including debt, equity, and preferred stock.

cost of equity: The cost of equity is the return required by equity investors for investing in a company, reflecting the risk associated with owning shares in that firm.