Cost of Preferred Stock

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

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

Cost of preferred stock is an important input in calculation of the weighted-average cost of capital (WACC).

Formula

Just like any other financial instrument, the value of a share of preferred stock equals the present value of its periodic cash flows (preferred dividends) determined at a discount rate (i.e. required rate of return) which represents the risk of the stock. This can be written as follows:

Value of Preferred Stock =Preferred Dividend per Share
Discount Rate

The discount rate in the equation above equals the required rate of return on preferred stock (i.e. its cost of preferred stock). Rearranging the above equation gives us the formula for cost of preferred stock:

Cost of Preferred Stock =Preferred Dividend per Share
Price per Share

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 20X2 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, ACA, CFA and last revised on