Cost of Preferred Stock

Cost of preferred stock is the rate of return required by the holders of a company's preferred stock. It is calculated by dividing the annual dividend payment on the preferred stock by the preferred stock's current market price.

In finance, the value of any asset equals the present value of its future net cash flows. In most cases, the cash flows stream of a preferred stock is a perpetuity because preferred stock has unlimited life and it pays a fixed amount of dividend each period. Value of a preferred stock is essentially the present value of the perpetuity.

PV of Perpetuity =Periodic Payment
Discount Rate

We can modify this relationship to come up with the formula for cost of preferred stock. The discount rate in the above relationship is the rate of return required by the holders of the preferred stock. The periodic payment is the fixed amount equal to the product of the stated percentage rate and the face value of the preferred stock while the present value of the perpetuity is the value of the preferred stock.

Substituting all the figures and rearranging, we get:

Formula

Cost of Preferred Stock = Annual Dividend on Preferred Stock
Current Market Price of Preferred Stock

Example

Wells Fargo & Company has 3,500,000 shares of $1,000 par value non-cumulative series L preferred stock. They carry annual fixed coupon rate of 7.5%. The preferred stock has a current market price on 29 December 2012 of $1,225.45. Find the cost of preferred stock.

Annual dividend payment = 7.5% of $1,000 = $75 per preferred stock

Cost of preferred stock = annual dividend payment ($75) ÷ current market price ($1225.45) = 6.12%

Written by Obaidullah Jan