Updated July 11, 2023
Definition of Cost of Preferred Stock
Cost of preferred stock refers to the cost which is paid by the company for issuing the preferred stock and it is calculated as the amount of money paid by the company for preferred stock divided by the collection of the net proceeds from issuing of preferred stock and it is used to measure the cost-effective ways to invest in.
Explanation
The C.P.S. (Cost of preferred stock) is the value that the organization pays with reference to issuing of stock and it may include dividend payment, brokerage or underwriting commission, etc. it is one of the effective ways to measure which investment option gives the minimum cost. It is also used for controlling the cost and optimum utilization of resources. It is used to calculate the weighted average cost of capital. It is used to compare which financing option is better if the company has two options i.e. to raise funds by preferred stock or by common stock the option which has a lower cost will be preferred for raising the funds. Preferred stocks have preference over regular stock. Preferred stocks have qualities of both shares and bonds and the holder of security are the owners of the organization to the extent of investment just like other shareholders. It is also calculated to analyze whether to issue shares or borrow funds for a particular project by analyzing the cost.
Formula for Cost of Preferred Stock
Formula for the C.P.S is as under:
Where the dividend is expected dividend i.e. current dividend plus growth if any.
Examples of Cost of Preferred Stock
The company has common stock trading at $ 500, the company needs the funds for expansion amounting to $ 5,000, for which it has two options available one is to issue the preferred stock and for which expected dividend is $ 50 and another option is to obtain loan from banks and for which interest is charged @ 7%. The rate of tax is 20%. Calculate the cost under each option and suggest which option is better?
Solution:
The C.P.S for shares is calculated as
C.P.S for Shares = Expected Dividend / Market Price
- C.P.Sk for Shares = $ 50 / $ 5,000 * 100
- C.P.S for Shares = 1.00%
Cost of Borrowings is calculated as
Cost of Borrowings = Cost of Debt (1 – Tax) / Debt Raised
- Cost of Borrowings = 350 (1 – 20%) / 5,000
- Cost of Borrowings = 5.60%
Hence the issue of preferred stock is preferable as the cost involved is low.
Cost of Preferred Stock Financing
The C.P.S in the case of financing is calculated to determine which financing option is better with the lowest cost. It is calculated as the cost of financing net-off tax divided by the finance raised. The formula is the same as the cost of preferred stock for borrowings.
In financing, the C.P.S is useful to analyze the cost and minimize it to the extent possible so as to earn maximum returns. It is also known as hybrid financing as preferred stock does not have maturity just like normal stocks and also, they provide a fixed rate of return just like bonds and debentures.
Importance of Cost of Preferred Stock
- It is used to analyze the various options for raising the funds thereby helping in reducing the overall cost.
- The C.P.S is an important tool used in calculating the weighted average cost of capital.
- It is attractive to the investors as the returns are assured.
- It is useful for analyzing the cost of all financing options and deciding whether the organization should go for the issue of normal stock or preferred stock based on the cost involved.
- The value of the stock is the present value.
Preferred vs Common Stock vs Debt
- Preferred stock is a special kind of equity ownership in which returns are fixed and the return on the common stock is based on the availability of the profits with the organization whereas the cost of debt is the statutory payment irrespective of the availability of profit.
- In terms of preference at the time of repayment or winding up debt is given the first preference; preferred stock is given the second preference and common stock will be given the last preference.
- The cost involved in preferred stock is more as they are much riskier and then the debt cost is less than the C.P.S finally, the common stock is involving the lowest cost.
- From an investor’s point of view, an investor’s first preference for investment is an investment in preferred stock, then common stock, and lastly in debentures as preferred stock gives more returns.
- In the case of both preferred stock and common stock, the investor is entitled to get ownership to the extent of investment whereas in the case of debt no investor is entitled to ownership.
Advantages
Some of the advantages are given below:
- Preferred stock has features of both common stock and bonds hence they are more attractive to investors.
- It helps to minimize the cost of stock and optimum utilization of resources.
- Preferred stock is used for the expansion of business, especially in risky projects.
- Preferred stock is flexible in nature and easily transferrable.
- The C.P.S is used as an analytical tool in the case of raising funds through multiple options.
Conclusion
Preferred stock is used for raising funds for different and risky projects. It is calculated as the cost of the project divided by the funds raised. It has features of common stock as well as debt as like debt the return is fixed and like common stock the preferred stocks are irredeemable. Calculation of cost of a preferred stock helps to minimize the cost by choosing the lowest cost model. Preferred stock is different from normal stock in terms of returns. As in preferred stock, the returns are assured whereas in normal stocks returns are given to investors if sufficient profits are available, whereas in the case of debt the installments are to be paid irrespective of profits available. The C.P.S is used for calculating the weighted average cost of capital.
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